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Table of Contents

 

 

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

[ X ]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2011

 

or

 

[     ]  TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 000-29660

 

 

SureWest Communications

(Exact name of registrant as specified in its charter)

 

 

California

 

 

68-0365195

 

 

(State or other jurisdiction

 

 

(IRS Employer

 

 

of incorporation or organization)

 

 

Identification No.)

 

 

 

 

 

 

 

8150 Industrial Avenue, Building A, Roseville, California

 

95678

 

 

(Address of principal executive offices)

 

(Zip Code)

 

 

 

(916) 786-6141

 

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes    X            No          

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes    X             No          

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer                   Accelerated filer    X   

 

Non-accelerated filer          (Do not check if a smaller reporting company)          Smaller reporting company         

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes                  No   X

 

On October 18, 2011, the registrant had 14,090,693 shares of Common Stock outstanding.

 

 

 

 

 




Table of Contents

 

PART 1 – FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS.

 

SUREWEST COMMUNICATIONS

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited; Amounts in thousands, except per share amounts)

 

 

 

Quarter Ended September 30,

 

Nine Months Ended September 30,

 

 

2011

 

2010

 

2011

 

2010

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating revenues:

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

$

48,018

 

 

$

43,861

 

 

$

139,356

 

 

$

129,514

 

Telecom

 

14,979

 

 

17,256

 

 

45,158

 

 

52,339

 

Total operating revenues

 

62,997

 

 

61,117

 

 

184,514

 

 

181,853

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

Cost of services and products (exclusive of depreciation and amortization)

 

28,566

 

 

26,672

 

 

81,352

 

 

78,771

 

Customer operations and selling

 

7,771

 

 

7,028

 

 

22,146

 

 

22,542

 

General and administrative

 

6,879

 

 

6,720

 

 

22,819

 

 

24,296

 

Depreciation and amortization

 

15,810

 

 

15,680

 

 

47,942

 

 

46,048

 

Total operating expenses

 

59,026

 

 

56,100

 

 

174,259

 

 

171,657

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income from operations

 

3,971

 

 

5,017

 

 

10,255

 

 

10,196

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

4

 

 

16

 

 

36

 

 

62

 

Interest expense

 

(2,497

)

 

(2,311

)

 

(9,512

)

 

(6,189

)

Other, net

 

(546

)

 

10

 

 

(249

)

 

(323

)

Total other income (expense), net

 

(3,039

)

 

(2,285

)

 

(9,725

)

 

(6,450

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

932

 

 

2,732

 

 

530

 

 

3,746

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax expense

 

289

 

 

1,328

 

 

211

 

 

2,342

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

643

 

 

$

1,404

 

 

$

319

 

 

$

1,404

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and diluted earnings per share

 

$

0.05

 

 

$

0.10

 

 

$

0.02

 

 

$

0.10

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares of common stock used to calculate basic and diluted earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

13,918

 

 

13,736

 

 

13,851

 

 

13,883

 

Diluted

 

14,023

 

 

13,736

 

 

13,944

 

 

13,883

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends declared per common share

 

$

0.08

 

 

$

 

 

$

0.16

 

 

$

 

 

 

See accompanying notes.

 

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Table of Contents

 

SUREWEST COMMUNICATIONS

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited; Amounts in thousands)

 

 

 

September 30,

 

December 31,

 

 

2011

 

2010

ASSETS

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

Cash and cash equivalents

 

 $

8,932

 

 

 $

2,937

 

Short-term investments

 

-

 

 

771

 

Accounts receivable, net

 

19,896

 

 

20,298

 

Income tax receivable

 

177

 

 

1,782

 

Prepaid expenses

 

2,875

 

 

3,792

 

Deferred income taxes

 

2,052

 

 

2,284

 

Assets held for sale

 

5,743

 

 

6,009

 

Total current assets

 

39,675

 

 

37,873

 

 

 

 

 

 

 

 

Property, plant and equipment, net

 

517,751

 

 

514,639

 

 

 

 

 

 

 

 

Intangible and other assets:

 

 

 

 

 

 

Customer relationships, net

 

1,721

 

 

2,632

 

Goodwill

 

45,814

 

 

45,814

 

Deferred charges and other assets

 

5,031

 

 

2,223

 

 

 

52,566

 

 

50,669

 

 

 

 $

609,992

 

 

 $

603,181

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

Current portion of long-term debt

 

 $

15,000

 

 

 $

15,636

 

Accounts payable

 

2,349

 

 

2,885

 

Other accrued liabilities

 

17,217

 

 

12,847

 

Advance billings and deferred revenues

 

8,148

 

 

8,035

 

Accrued compensation

 

8,192

 

 

6,998

 

Total current liabilities

 

50,906

 

 

46,401

 

 

 

 

 

 

 

 

Long-term debt

 

191,250

 

 

189,773

 

Deferred income taxes

 

55,311

 

 

56,661

 

Accrued pension and other post-retirement benefits

 

34,960

 

 

33,815

 

Other liabilities and deferred revenues

 

5,978

 

 

4,473

 

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

Common stock, without par value; 100,000 shares authorized, 14,091 and 13,866 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively

 

146,177

 

 

143,309

 

Accumulated other comprehensive loss

 

(16,359

)

 

(15,081

)

Retained earnings

 

141,769

 

 

143,830

 

Total shareholders’ equity

 

271,587

 

 

272,058

 

 

 

 $

609,992

 

 

 $

603,181

 

 

 

See accompanying notes.

 

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Table of Contents

 

SUREWEST COMMUNICATIONS

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; Amounts in thousands)

 

 

 

Nine Months Ended September 30,

 

 

2011

 

2010

 

 

 

 

 

 

 

Net cash provided by operating activities

 

 $

61,189

 

 

 $

46,509

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

Capital expenditures for property, plant and equipment

 

(50,781

)

 

(39,271

)

Proceeds from sale of property and equipment

 

624

 

 

 

Proceeds from sale of available-for-sale securities

 

783

 

 

3,700

 

Purchases of available-for-sale securities

 

(10

)

 

(28

)

Proceeds from sale of discontinued operations

 

 

 

1,725

 

Net cash used in investing activities

 

(49,384

)

 

(33,874

)

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

Proceeds from issuance of long-term debt

 

170,000

 

 

8,069

 

Principal payments on long-term debt

 

(169,159

)

 

(22,069

)

Payment of debt issuance costs

 

(3,565

)

 

 

Dividends paid

 

(2,256

)

 

 

Repurchases and surrenders of common stock

 

(830

)

 

(2,909

)

Net cash used in financing activities

 

(5,810

)

 

(16,909

)

 

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

5,995

 

 

(4,274

)

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

2,937

 

 

7,489

 

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

 $

8,932

 

 

 $

3,215

 

 

 

See accompanying notes.

 

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Table of Contents

 

SUREWEST COMMUNICATIONS

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited; Amounts in thousands, except share and per share amounts)

 

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Business and Basis of Accounting

 

SureWest Communications (the “Company”, “we” or “our”) is a holding company with operating subsidiaries that provide communications services in Northern California, primarily the greater Sacramento region (“Sacramento region”), and the greater Kansas City, Kansas and Missouri areas (“Kansas City area”). Our operating subsidiaries are SureWest Broadband, SureWest TeleVideo, SureWest Kansas, Inc., (“SureWest Kansas” or the “Kansas City operations”), SureWest Telephone and SureWest Long Distance.

 

We expect that the sources of our revenues and our cost structure may be different in future periods, both as a result of our entry into new communications markets and competitive forces in each of the markets in which we have operations.

 

In the opinion of management, the accompanying condensed consolidated balance sheets and related interim statements of income and cash flows include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States (“U.S. GAAP” or “GAAP”) for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such SEC rules and regulations and accounting principles applicable for interim periods. Events subsequent to the balance sheet date have been evaluated for inclusion in the accompanying condensed consolidated financial statements through the date of issuance.  Management believes that the disclosures made are adequate to make the information presented not misleading. Interim results are not necessarily indicative of results for a full year.  The information presented in this Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto included in our 2010 Annual Report on Form 10-K filed with the SEC.

 

Other Adjustments

 

Our subsidiaries provide services to customers for which they are required to contribute to the universal service fund (“USF”). Each subsidiary collects USF fees from its customers and we remit these amounts to the Universal Service Administrative Company (“USAC”), the administrator of the Federal USF.  SureWest Telephone provides wholesale transport services to SureWest Broadband, which SureWest Broadband resells to its own customers.  The SureWest Broadband services are subject to USF fees.  During the quarter ended June 30, 2011, we determined that SureWest Telephone remitted USF fees to USAC relating to the wholesale transport for voice services which it sells to SureWest Broadband for the year ended December 31, 2010 and the quarters ended March 31, 2011 and June 30, 2011.  We also determined that SureWest Broadband had remitted USF fees to USAC relating to the voice services provided to its customers during the same time periods, including those services utilizing SureWest Telephone wholesale transport.  Wholesale transport services provided by SureWest Telephone to SureWest Broadband for the resale as voice services are not subject to USF fees for SureWest Telephone generally because USF contributions are being collected from the end user customers of SureWest Broadband who use these resold wholesale services.  Accordingly, in June 2011, SureWest Telephone filed an amended remittance form with USAC to recover $906 of the fees paid for the year ended December 31, 2010.  During the quarter ended September 30, 2011, USAC approved our amended filing and the USF fees are being refunded to SureWest Telephone monthly through the first quarter of 2012.  The USF fees of $303 and $329 for the quarters ended March 31, 2011 and June 30, 2011, respectively, will be refunded to SureWest Telephone based on its annual remittance form to be filed with USAC during the first quarter of 2012. In addition, SureWest Broadband recorded a $218 reduction to its USAC expense during the quarter ended June 30, 2011 relating to revised estimates to its interstate traffic that will be included in its annual remittance form to be filed with USAC in the first quarter of 2012.  We expect to receive the refunds from the annual remittance filings during the third quarter of 2012.  For the fees relating to 2010 and the quarter ended March 31, 2011, we recognized a

 

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reduction in operating expense (within costs of services and products) on the condensed consolidated statements of income of $1,427 for the nine-month period ended September 30, 2011.  This resulted in an increase to consolidated net income by $856 ($0.06 per share) for the nine months ended September 30, 2011 and a corresponding receivable of $1,756 on the condensed consolidated balance sheets. We received repayment of $307 from USAC during the third quarter of 2011 for the fees related to 2010 and expect to receive the remaining short-term receivable balance of $1,449 by the end of the third quarter of 2012.

 

Recent Developments

 

Assets Held For Sale

 

Assets held for sale consist of certain real estate assets that we have committed to sell or are currently marketed for sale.  These regulated assets, which are included in the Telecommunications (“Telecom”) segment, include 21 acres of undeveloped land and two office buildings.

 

The following is the carrying value of the assets held for sale as of September 30, 2011 and December 31, 2010:

 

 

 

September 30,

 

December 31,

 

 

 

2011

 

2010

 

Undeveloped land

 

$

1,556

 

$

1,556

 

Office buildings

 

4,187

 

4,453

 

 

 

$

5,743

 

$

6,009

 

 

In May 2011, we entered into an agreement to sell office facilities, which included developed land, an office building and vehicle parking structure, for a purchase price of $1,900 and as a result, classified these assets as assets held for sale during the quarter ended June 30, 2011. In connection with the classification to assets held for sale, no impairment charge was recognized as the estimated fair value less selling costs exceeded the carrying value of the assets. The sale is expected to close by December 31, 2011. Upon the close of the sale, a gain of approximately $560 will be recorded against accumulated depreciation, in accordance with regulated telephone plant and equipment composite group remaining life methodology. For the non-depreciable assets included in the sale, a gain of approximately $235 will be recognized in the condensed consolidated statements of income upon the completion of the close of the sale.

 

In August 2011, we entered into an agreement to sell an office building included in assets held for sale for a purchase price of $3,500.  The sale is expected to close by the end of the second quarter of 2012.  During the quarter ended September 30, 2011, the carrying value of the office building was reduced to its fair value less estimated selling costs. As a result, an impairment charge of $1,210 was recorded against accumulated depreciation during the quarter ended September 30, 2011, in accordance with regulated telephone plant and equipment composite group remaining life methodology.  For the non-depreciable assets included in the sale, an impairment loss of $43 was recognized in the condensed consolidated statements of income during the quarter ended September 30, 2011.

 

Recently Issued Accounting Pronouncements

 

In September 2011, the Financial Accounting Standards Board (“FASB”) issued the Accounting Standards Update (“ASU”) to permit an entity the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the first step of the two-step goodwill impairment test. Accordingly, based on the option created by the amended guidance, the calculation of a reporting unit’s fair value is not required unless, as a result of the qualitative assessment, it is more likely than not that fair value of the reporting unit is less than its carrying amount. The amended guidance, which should be applied prospectively, becomes effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We are currently evaluating the impact this update will have on our condensed consolidated financial statements.

 

In May 2011, as part of ongoing efforts with the International Accounting Standards Board to achieve convergence, the FASB issued the ASU on fair value measurements and disclosures to (i) clarify the application of existing fair value measurement and disclosure requirements and (ii) change a particular principle or requirement for measuring fair value or disclosing information about fair value measurements.  The amendments in this ASU are effective for public entities for interim and annual periods beginning after December 15, 2011 and should be applied prospectively, with early application not permitted. We are currently evaluating the impact this update will have on our condensed consolidated financial statements.

 

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In June 2011, the financial statement presentation of comprehensive income was amended by an ASU issued by the FASB to (i) eliminate the option to present the components of other comprehensive income (“OCI”) in the statement of changes in stockholder’s equity, (ii) require presentation of net income and OCI and their respective components either in a single continuous statement or in two separate but consecutive statements and (iii) require presentation of reclassification adjustments on the face of the statement. The amendments in this ASU do not change (i) the items that must be reported in OCI or when an item of OCI must be reclassified to net income or (ii) the option for an entity to present components of OCI either net of related tax effects or before related tax effects. Amendments to comprehensive income should be applied retrospectively and become effective for public entities for interim and annual periods beginning after December 15, 2011 with early adoption permitted. We are currently evaluating the impact this update will have on our condensed consolidated financial statements.

 

Recently Adopted Accounting Pronouncements

 

On January 1, 2011, we adopted the ASU regarding business combinations.  The updated guidance requires a public entity to disclose pro forma revenue and earnings for a business combination occurring in the current year as though the business combination occurred as of the beginning of the year or, if comparative statements are presented, pro forma amounts are required to be presented as though the business combination took place as of the beginning of the comparative year.  In addition, it also expands the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings.  The provisions of this updated guidance will be applied prospectively to business combinations consummated subsequent to January 1, 2011.  Our adoption of this guidance did not impact our condensed consolidated financial position or results of operations.

 

On January 1, 2011, we prospectively adopted the ASU that clarifies when the circumstances under which step 2 of the goodwill impairment test must be performed for reporting units with zero or negative carrying amounts and the qualitative factors to be taken into account when performing step 2 in determining whether it is more likely than not that an impairment exists.  The adoption of this guidance did not impact our condensed consolidated financial position or results of operations.

 

On January 1, 2011, we prospectively adopted the ASU regarding revenue recognition for multiple-deliverable arrangements.  The updated guidance provides for a new methodology for establishing the fair value for a deliverable in a multiple-element arrangement.  When vendor specific objective or third-party evidence for deliverable in a multiple-element arrangement cannot be determined, an enterprise is required to develop a best estimate of the selling price of separate deliverables and to allocate the arrangement consideration using the relative selling price method.  The adoption of this guidance did not have a material impact on our condensed consolidated financial position or results of operations.

 

Earnings and Dividends Per Share

 

Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to common stockholders by the weighted average number of common shares outstanding during the period.

 

Diluted earnings (loss) per share (“diluted EPS”) is computed based on the weighted average number of common shares plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method.  Dilutive potential common shares include time and performance based stock awards and stock units.  Diluted EPS excludes the impact of potential common shares related to our stock options in periods where the option exercise price is greater than the average market price of our common stock.

 

Diluted EPS for the three and nine-month periods ended September 30, 2010 exclude potential common shares because their inclusion would have had an anti-dilutive effect.

 

Cash dividends per share are based on the actual dividends per share, as declared by the Company’s Board of Directors. On each date that the Company pays a cash dividend to the holders of the Company’s common stock, the Company credits to the holders of restricted stock units and performance share units (collectively “stock units”) an additional number of stock units equal to the total number of whole stock units and additional stock units previously credited to the holders, multiplied by the dollar amount of the cash dividend per share of common stock. Any fractional stock units resulting from such calculation are included in the additional stock units.

 

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2. FAIR VALUE MEASUREMENTS & FINANCIAL INSTRUMENTS

 

Investments

 

The following is a summary of our short-term available-for-sale investments as of December 31, 2010:

 

 

 

As of December 31, 2010

 

 

 

Adjusted
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Estimated
Fair
Market
Value

 

Equity securities

 

  $

727

 

  $

44

 

  $

 

  $

771

 

 

During the quarter ended March 31, 2011, we sold our short-term available-for-sale investments and we recognized a gain of approximately $103 in other income (expense), other, net on the condensed consolidated statements of income.

 

Cost Method Investments

 

Cost method investments are originally recorded at cost, and we record dividend income or patronage income when they are declared. Cost method investments are reported as other long-term assets in our condensed consolidated balance sheets. Dividend income is reported in other income (expense), interest income in our condensed consolidated statements of income and patronage income is reported against other income (expense), interest expense in our condensed consolidated statements of income.  We held $1,430 and $1,115 in cost method investments which were included in other long-term assets in the condensed consolidated balance sheets as of September 30, 2011 and December 31, 2010, respectively. Our cost method investments primarily consist of our investment in CoBank, ACB (“CoBank”) and are related to patronage distributions of restricted equity.  Our investment in CoBank is required in accordance with the provisions of our Credit Agreement (see Note 3) held by CoBank.  We review all of our cost method investments quarterly to determine if impairment indicators are present; however, we are not required to determine the fair value of these investments unless impairment indicators exist. We estimate that the fair value of our cost method investments approximates their carrying values as of September 30, 2011 and December 31, 2010.

 

Fair Value of Financial Instruments

 

We account for certain assets and liabilities at fair value.  Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. A financial asset or liability’s classification within a three-tiered value hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The hierarchy prioritizes the inputs used in the valuation methodologies in measuring fair value:

 

Level 1 – Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.

 

Level 2 – Inputs that reflect quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in inactive markets and inputs other than quoted prices that are directly or indirectly observable in the marketplace.

 

Level 3 – Unobservable inputs which are supported by little or no market activity.

 

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The following tables summarize our financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2011 and December 31, 2010:

 

 

 

As of September 30, 2011

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Assets

 

 

 

 

 

 

 

 

 

Interest rate caps

 

 $

62

 

 $

 –

 

 $

62

 

 $

 –

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Interest rate swap

 

 $

1,755

 

 $

 –

 

 $

1,755

 

 $

 –

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2010

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Money market funds

 

 $

84

 

 $

84

 

 $

 –

 

 $

 –

 

Equity securities

 

771

 

771

 

 –

 

 –

 

 

 

 $

855

 

 $

855

 

 $

 –

 

 $

 –

 

 

Fair values for cash equivalents were determined by quoted market prices.  Fair values for interest rate caps and interest rate swaps are valued using models based on readily observable market parameters for all substantial terms and are classified within Level 2. See Note 4 for further discussion regarding our interest rate caps and interest rate swap.

 

Fair Value of Debt

 

We had no short-term borrowings as of September 30, 2011 and December 31, 2010. The fair value of our long-term debt was estimated using discounted cash flow analyses based on incremental borrowing rates for similar types of borrowing arrangements.

 

 

 

As of September 30, 2011

 

As of December 31, 2010

 

 

 

Carrying Value

 

Fair Value

 

Carrying Value

 

Fair Value

 

Long-term debt (including current maturities)

 

 $

206,250

 

 $

204,301

 

 $

205,409

 

 $

203,459

 

 

3. CREDIT ARRANGEMENTS

 

A summary of our long-term debt is as follows:

 

 

 

Weighted Average Interest Rates

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

 

 

 

September 30,

 

December 31,

 

 

 

2011

 

2010

 

Maturity Date

 

2011

 

2010

 

Secured Term Loan B credit facility

 

3.63%

 

 

March 2016

 

$

206,250

 

$

-

 

Unsecured Series A Senior Notes

 

 

6.30%

 

 

 

10,909

 

Unsecured Series B Senior Notes

 

 

4.74%

 

 

 

36,000

 

Unsecured Revolving Loan credit facility

 

 

2.56%

 

 

 

8,500

 

Unsecured Term Loan A credit facility

 

 

3.97%

 

 

 

120,000

 

Unsecured Term Loan B credit facility

 

 

2.56%

 

 

 

30,000

 

Total long-term debt

 

 

 

 

 

 

 

206,250

 

205,409

 

Less current portion

 

 

 

 

 

 

 

15,000

 

15,636

 

Total long-term debt, net of current

 

 

 

 

 

 

 

$

191,250

 

$

189,773

 

 

In March 2011, we entered into a $264,000 five-year senior secured Credit Agreement (“Credit Agreement”) to replace our unsecured Third Amended and Restated Credit Agreement (“Previous Agreement”) from September 2008.  The proceeds from the Credit Agreement were used to repay the Previous Agreement in its entirety and to repay the unsecured Series A and Series B Senior Notes issued in December 1998 and March 2003, respectively.

 

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The Credit Agreement included (i) a $34,000 Revolving Loan Facility, which includes a $6,000 swingline loan commitment and a $5,000 commitment for the issuances of letters of credit, each as a subfacility to the Revolving Loan Facility, (ii) a fully drawn $40,000 Term A Loan Facility and (iii) a $190,000 Term Loan B Commitment. On May 31, 2011, the Term Loan A Facility matured and converted to a Term Loan B borrowing thus increasing the Term Loan B Commitment by $40,000 to $230,000.  The Term Loan B Commitment includes a delayed draw amount which allows for one or more additional advances not to exceed $20,000. The delayed draw may be used solely for capital expenditures.  All amounts outstanding on the Revolving Loan Facility and the Term Loan B Facility will be due on March 2, 2016.  As of September 30, 2011, no amounts were outstanding under the Revolving Loan facility.

 

In connection with entering into the Credit Agreement, we incurred $3,565 in debt issuance costs of which $301 were recognized during the quarter ended March 31, 2011. The remaining deferred debt issuance costs will be amortized over the term of the Credit Agreement.  In addition, we incurred early termination fees of $2,346 related to the repayment of our Series A and Series B Senior Notes during the quarter ended March 31, 2011.  The early termination fees and the debt issuance costs expensed were recognized in other income (expense), interest expense in the condensed consolidated statements of income during the nine-month period ended September 30, 2011.

 

Commencing on September 30, 2011, and on the last day of each quarter thereafter, principal payments for the Term Loan B Facility are due in equal quarterly amounts of $3,750.  In addition, we must make mandatory repayments under certain circumstances upon receipt of proceeds from insurance, asset dispositions, debt issuances and equity issuances.

 

At September 30, 2011, the aggregate maturities of long-term debt were (i) $3,750 in 2011, (ii) $15,000 annually in 2012 through 2015 and (iii) $142,500 in 2016 for a total of $206,250.

 

Borrowings under the Credit Agreement (other than the swingline loan) will bear interest based, at our election, on the London Interbank Offered Rate (“LIBOR”) or the bank’s base rate in either case, plus an applicable margin based on our leverage ratio.  The swingline loan will accrue interest at the base rate, plus an applicable margin.

 

Our obligations under the Credit Agreement are secured by a first priority security interest in essentially all our current and future assets.  Security includes the capital stock we own or should acquire in all of our subsidiaries.

 

The Credit Agreement includes financial and operating covenants that may limit the incurrence of additional indebtedness, investments, the payment of dividends, the making of certain other restricted payments, transactions with affiliates, liens, mergers, asset sales and material changes in our business.  The Credit Agreement also requires us to maintain certain financial ratios and minimum levels of tangible net worth.

 

Our financial covenants as defined in the Credit Agreement, measured quarterly, are as follows:

 

 Financial Covenant

 

Required Ratio Level

 

Actual Performance at
September 30, 2011

 Leverage ratio

 

Not more than 3.00

 

2.44

 Interest coverage ratio

 

Not less than 3.50

 

7.24

 Consolidated net worth

 

Not less than $200,000

 

$287,946

 

4. DERIVATIVES

 

We use derivative instruments to manage our interest rate exposure associated with our variable-rate debt and to achieve a desired proportion of fixed and variable-rate debt. At the inception of a hedge transaction, we formally document the relationship between the hedging instruments including our objective and strategy for establishing the hedge.  In addition, the effectiveness of the derivative instrument is assessed at inception and on an ongoing basis. Counterparties to derivative instruments expose us to credit related losses in the event of nonperformance. We execute agreements only with financial institutions we believe to be creditworthy and regularly assess the creditworthiness of each of the counterparties.  We do not use derivative instruments for trading or speculative purposes.

 

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Table of Contents

 

All derivative instruments are recorded at fair value in the condensed consolidated balance sheet.  For derivatives designated as a cash flow hedge, the effective portion of the change in the fair value is recognized as a component of accumulated other comprehensive loss.  The change in fair value related to the ineffective portion of the hedge, if any, is immediately recognized as interest expense in the condensed consolidated statement of income. Amounts in accumulated other comprehensive loss will be reclassified to earnings when the related hedged items impact earnings.  Cash flows from derivative instruments are classified in operating activities in the condensed consolidated statement of cash flows, which is consistent with the items being hedged.

 

In June 2011, we entered into an interest rate swap agreement and two interest rate cap agreements. These agreements have been designated as cash flow hedges. The swap agreement is on a notional amount of $75,000 with a fixed rate of 1.85%. This fixes the total interest expense on $75,000 of our outstanding long-term debt at 5.10%, which includes the fixed rate of 185 basis points plus our applicable interest margin of 325 basis points. The interest rate swap agreement is effective June 30, 2011 and ends March 2, 2016 with a cancellation provision on June 30, 2014.  The interest rate swap agreement contains standard credit-risk-related contingent features which could result in the counterparty requesting termination and immediate settlement of the contract in the event of default.

 

The interest rate cap agreements each have a notional amount of $25,000 with a 2.00% strike price and are effective June 30, 2011 through June 30, 2014 and August 31, 2011 through March 2, 2014, respectively.  In June 2011, we paid premiums of $333 to enter into the interest rate cap agreements.  The premiums are being amortized to interest expense over the term of the agreement.

 

Fair values of derivative instruments in the condensed consolidated balance sheet at September 30, 2011 consisted of:

 

 

 

Classification

 

Fair Value

 

 

 

 

 

 

 

Asset derivatives

 

 

 

 

 

Interest rate caps

 

Deferred charges and other assets

 

$

62 

 

 

 

 

 

 

 

Liability derivatives

 

 

 

 

 

Interest rate swap

 

Other liabilities and deferred revenues

 

$

1,755 

 

 

We did not have any derivative instruments at December 31, 2010.

 

The effect of derivative instruments on the condensed consolidated statements of income for the quarter and nine-month period ended September 30, 2011 consisted of: 

 

 

 

Classification

 

Quarter and Nine
Months Ended
September 30,
2011

 

 

 

 

 

 

 

Interest rate caps

 

 

 

 

 

Loss recognized in other comprehensive income (effective portion)

 

Accumulated other comprehensive loss

 

$

(271

)

 

 

 

 

 

 

Interest rate swap

 

 

 

 

 

Loss recognized in other comprehensive income (effective portion)

 

Accumulated other comprehensive loss

 

$

(1,755

)

Loss reclassified from accumulated other comprehensive income into income (effective portion)

 

Interest Expense

 

$

(307

)

 

We expect to reclassify $1,125 of the net loss included in accumulated other comprehensive loss into earnings during the next 12 months.

 

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Table of Contents

 

5. EQUITY

 

Share-Based Compensation

 

Stock Plan

 

Our Board of Directors may grant share-based awards from our shareholder approved Equity Incentive Plan, the 2000 Equity Incentive plan (the “Stock Plan”), to certain employees, outside directors and consultants.  The Stock Plan permits issuance of awards in the form of restricted shares, stock units, performance shares, options or stock appreciation rights.  Under the Stock Plan, approximately 2.2 million shares of our common stock are authorized for issuance, including those outstanding as of September 30, 2011.

 

Time Based Stock Awards and Units

 

We measure the fair value of time-based restricted stock awards (“RSAs”) and restricted stock units (“RSUs”) based upon the market price of the underlying common stock as of the date of the grant.  RSAs and RSUs are amortized over their respective vesting periods, generally from immediate vest to a four-year vesting period using the straight-line method.  We have estimated expected forfeitures based on historical experience and are recognizing compensation only for those RSAs and RSUs expected to vest.

 

The following table summarizes the grants of time-based RSAs and RSUs that occurred under the Stock Plan during the nine-month periods ended September 30, 2011 and 2010.  No RSAs or RSUs were granted during the quarters ended September 30, 2011 and 2010.

 

 

Nine Months Ended September 30,

 

 

 

Grant Date

 

 

 

Grant Date

 

 

2011

 

FairValue

 

2010

 

Fair Value

 

RSAs Granted

212,654    

 

$

12.00

 

217,575

 

 

$

9.95

 

RSUs Granted

78,614    

 

$

10.78

 

92,709

 

 

$

9.95

 

Total

291,268    

 

 

 

310,284

 

 

 

 

 

The following summarizes the time-based RSA and RSU stock activity during the nine-month period ended September 30, 2011:

 

 

 

 

 

 

Weighted Average

 

 

 

Shares

 

 

Grant Date Fair Value

 

 

 

 

 

 

 

 

Nonvested-January 1, 2011

 

396,343

 

 

$11.17

 

Granted

 

291,268

 

 

$11.67

 

Vested

 

(191,937

)

 

$11.32

 

Forfeited

 

 

 

 

 

Nonvested-September 30, 2011

 

495,674

 

 

$11.40

 

 

The total fair value of the RSAs and RSUs that vested during the nine-month period ended September 30, 2011 was $2,174.

 

Performance Share Awards and Units

 

We derive the fair value of performance share awards (“PSAs”) and performance share units (“PSUs”) (collectively “the awards”) using the Monte Carlo Simulation (“MCS”) valuation method.  The MCS utilizes multiple input variables to determine the probability of the Company achieving the market condition and the derived fair value of the awards. PSAs and PSUs are generally granted in six vesting tranches over a vesting period ranging from thirty to thirty-five months.  The awards vest based on the achievement of stock price appreciation and continuous employee service over the life of the award.  As of each vesting date, each tranche vests if the average closing stock price of the SureWest common stock for the eleven trading day period, beginning five days before the corresponding target date and ending five days after the corresponding target date, is equal to or exceeds the respective target stock price.  If the tranche does not meet the target stock price condition on its corresponding target date, then it may vest at a subsequent target date if the stock price condition is met.  However, the tranche may not vest earlier than its corresponding target date. The fair values of the awards are amortized over the derived service period of each vesting tranche. We have estimated expected forfeitures based on historical experience and are recognizing compensation only for those PSAs and PSUs expected to vest.

 

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The following table summarizes the grants of PSAs and PSUs that occurred under the Stock Plan during the nine-month period ended September 30, 2011. No PSAs or PSUs were granted during the quarter ended September 30, 2011 or the quarter and nine-month period ended September 30, 2010.

 

 

 

Nine Months Ended

 

 

 

September 30, 2011

 

 

 

Shares
Granted

 

FairValue

 

PSAs

 

73,012

 

 

$

9.68 

 

PSUs

 

19,712

 

 

$

8.32 

 

Total

 

92,724

 

 

 

 

 

The following table summarizes the PSA and PSU activity during the nine-month period ended September 30, 2011:

 

 

 

Shares

 

 

Weighted Average Grant
Date Fair Value

 

Nonvested-January 1, 2011

 

 

 

 

 

Granted

 

92,724

 

 

 

$

9.39

 

 

Vested

 

(13,828

)

 

 

$

10.22

 

 

Forfeited

 

(6,764

)

 

 

$

8.06

 

 

Nonvested-September 30, 2011

 

72,132

 

 

 

$

9.36

 

 

 

The total fair value of the PSAs and PSUs that vested during the nine-month period ended September 30, 2011 was $141.

 

Share Based Compensation Expense

 

The following table summarizes total compensation costs recognized for share-based payments during the quarters and nine-month periods ended September 30, 2011 and 2010:

 

 

 

Quarter Ended September 30,

 

 

 

Nine Months Ended
September 30,

 

 

2011

 

 

 

2010

 

 

 

2011

 

 

 

2010

 

RSAs(1)

 

$

438

 

 

 

$

109

 

 

 

$

2,377

 

 

 

$

1,526

 

RSUs

 

$

181

 

 

 

$

158

 

 

 

$

765

 

 

 

$

685

 

PSAs

 

$

108

 

 

 

$

 

 

 

$

338

 

 

 

$

 

PSUs

 

$

20

 

 

 

$

 

 

 

$

94

 

 

 

$

 

Total

 

$

747

 

 

 

$

267

 

 

 

$

3,574

 

 

 

$

2,211

 

 

(1) Pursuant to a severance agreement entered into on March 31, 2011 between the Company and a retiring officer, share-based compensation expense recognized during the nine months ended September 30, 2011 included approximately $859 related to the acceleration of unvested, time-based RSAs.

 

As of September 30, 2011, total unrecognized compensation costs related to nonvested RSAs, RSUs, PSAs, and PSUs was $5,151 and will be recognized over a weighted-average period of approximately 2.33 years.

 

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Table of Contents

 

Other Comprehensive Income

 

Significant components of our other comprehensive income are as follows:

 

 

 

Quarter Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2011

 

 

 

2010

 

 

 

2011

 

 

 

2010

 

Net income

 

 

$

643

 

 

 

$

1,404

 

 

 

  $

319

 

 

 

$

1,404

 

Available-for-sale investments:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized gain (loss) on available-for-sale investments, net of tax

 

 

 

 

 

56

 

 

 

(3

)

 

 

(2

)

Reclassification adjustment for gain included in net loss, net of tax

 

 

 

 

 

 

 

 

(57

)

 

 

 

Derivative instruments designated as cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized loss on cash flow hedges, net of tax

 

 

(1,218

)

 

 

 

 

 

(1,218

)

 

 

 

Comprehensive income (loss)

 

 

$

(575

)

 

 

$

1,460

 

 

 

  $

(959

)

 

 

$

1,402

 

 

6.  PENSION PLAN AND OTHER POST-RETIREMENT BENEFITS

 

We maintain a frozen noncontributory defined benefit pension plan (the “Pension Plan”) which covers certain eligible employees. Benefits are based on years of service and the employee’s average compensation during the five highest consecutive years of the last ten years of credited service. Our funding policy is to contribute annually an actuarially determined amount consistent with applicable federal income tax regulations. Contributions are intended to provide for benefits attributed to service to date.  Pension Plan assets are primarily invested in domestic equity securities, fixed income and international equity securities.

 

We also maintain an unfunded Supplemental Executive Retirement Plan (“SERP”), which provides supplemental retirement benefits to certain of our retired executives. The SERP provides for incremental pension payments to partially offset the reduction in amounts that would have been payable under the Pension Plan if it were not for limitations imposed by federal income tax regulations.

 

In addition, we provide certain post-retirement benefits other than pensions (“Other Benefits Plan”) to certain eligible employees of our California location, including life insurance benefits and a stated reimbursement for Medicare supplemental insurance.

 

Effective April 1, 2007, we amended our Pension Plan, SERP and Other Benefits Plan (collectively the “Plans”) such that the Plans were frozen so that no person is eligible to become a new participant on or following that date and all future benefit accruals for existing participants under the Plans cease.

 

Components of Net Periodic Pension Cost

 

The following table summarizes the benefit costs related to our Pension and SERP Plans:

 

Quarter Ended September 30,

 

 

2011

 

 

 

2010

 

Interest cost on projected benefit obligation

 

 

$

1,751

 

 

 

$

1,792

 

Expected return on plan assets

 

 

(1,865

)

 

 

(1,820

)

Amortization of:

 

 

 

 

 

 

 

 

Prior Service Cost

 

 

-

 

 

 

1

 

Net actuarial loss

 

 

623

 

 

 

543

 

Net periodic pension expense

 

 

$

509

 

 

 

$

516

 

 

Nine Months Ended September 30,

 

 

2011

 

 

 

2010

 

Interest cost on projected benefit obligation

 

 

$

5,252

 

 

 

$

5,376

 

Expected return on plan assets

 

 

(5,596

)

 

 

(5,460

)

Amortization of:

 

 

 

 

 

 

 

 

Prior service cost

 

 

-

 

 

 

2

 

Net actuarial loss

 

 

1,870

 

 

 

1,630

 

Net periodic pension expense

 

 

$

1,526

 

 

 

$

1,548

 

 

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Table of Contents

 

Net periodic benefit costs related to the Other Benefits Plan were not significant to our condensed consolidated financial statements for the quarters or nine-month periods ended September 30, 2011 and 2010.

 

7.  INCOME TAXES

 

Our effective federal income tax rates were 39.8% and 62.5% for the nine-month periods ended September 30, 2011 and 2010, respectively. For the nine-month period ended September 30, 2011, our actual tax expense differed from the federal statutory rate primarily due to state taxes, permanent differences resulting from favorable tax treatment of dividends both paid and received and the release of unrecognized tax benefits.  These favorable differences were offset by a change to state deferred tax expense attributable to apportionment changes.

 

Our policy is to recognize interest and penalties related to uncertain tax positions as additional income tax expense.  We did not accrue significant amounts of interest and penalties related to unrecognized tax benefits during the nine-month periods ended September 30, 2011 and 2010.

 

The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $98 and $176 at September 30, 2011 and December 31, 2010, respectively.  We recognized $110 of previously unrecognized tax benefits during the third quarter of 2011 as a result of the expiration of the statute of limitations.

 

As of September 30, 2011, the following tax years and related taxing jurisdictions were open:

 

Tax Year

 

Taxing Jurisdiction

2008 - 2010

 

Federal

2006 - 2010

 

California

2006 - 2010

 

Kansas and Missouri

 

8.  BUSINESS SEGMENTS

 

We have two reportable business segments: Broadband and Telecom. We have aggregated certain of our operating segments within the Broadband and Telecom segments because we believe that such operating segments share similar economic characteristics.  We measure and evaluate the performance of our segments based on income (loss) from operations. Corporate Operations are allocated to the appropriate segment, except for cash; investments; certain property, plant, and equipment; and miscellaneous other assets, which are not allocated to the segments.  However, the interest income associated with cash and investments held by Corporate Operations is included in the results of the operations of our segments.

 

Our business segment information is as follows:

 

 

 

 

 

 

 

Intercompany

 

 

 

 

 

Broadband

 

Telecom

 

Eliminations

 

Consolidated

 

For the three months ended September 30, 2011:

 

 

 

 

 

 

 

 

 

Operating revenues from external customers

 

  $

48,018

 

 $

14,979

 

  $

 

  $

62,997

 

Intersegment revenues

 

152

 

5,231

 

(5,383)

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Cost of services and products*

 

27,407

 

5,898

 

(4,739)

 

28,566

 

Customer operations and selling

 

5,624

 

2,667

 

(520)

 

7,771

 

General and administrative

 

4,148

 

2,855

 

(124)

 

6,879

 

Depreciation and amortization

 

12,574

 

3,236

 

 

15,810

 

Income (loss) from operations

 

(1,583)

 

5,554

 

 

3,971

 

Net income (loss)

 

  $

(2,801)

 

 $

3,444

 

  $

 

  $

643

 

 

 

 

 

 

 

 

 

 

 

*Exclusive of depreciation and amortization

 

 

 

 

 

 

 

 

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Table of Contents

 

 

 

 

 

 

 

Intercompany

 

 

 

 

 

Broadband

 

Telecom

 

Eliminations

 

Consolidated

 

For the three months ended September 30, 2010:

 

 

 

 

 

 

 

 

 

Operating revenues from external customers

 

  $

43,861

 

  $

17,256

 

  $

 

  $

61,117

 

Intersegment revenues

 

110

 

5,275

 

(5,385)

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Cost of services and products*

 

25,719

 

5,677

 

(4,724)

 

26,672

 

Customer operations and selling

 

4,940

 

2,621

 

(533)

 

7,028

 

General and administrative

 

3,645

 

3,203

 

(128)

 

6,720

 

Depreciation and amortization

 

12,609

 

3,071

 

 

15,680

 

Income (loss) from operations

 

(2,942)

 

7,959

 

 

5,017

 

Net income (loss)

 

  $

(3,082)

 

  $

4,486

 

  $

 

  $

1,404

 

 

 

 

 

 

 

 

 

 

 

*Exclusive of depreciation and amortization

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Intercompany

 

 

 

 

 

Broadband

 

Telecom

 

Eliminations

 

Consolidated

 

For the nine months ended September 30, 2011:

 

 

 

 

 

 

 

 

 

Operating revenues from external customers

 

  $

139,356

 

  $

45,158

 

  $

 

  $

184,514

 

Intersegment revenues

 

467

 

15,579

 

(16,046)

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Cost of services and products*

 

79,741

 

15,716

 

(14,105)

 

81,352

 

Customer operations and selling

 

15,995

 

7,716

 

(1,565)

 

22,146

 

General and administrative

 

13,404

 

9,791

 

(376)

 

22,819

 

Depreciation and amortization

 

38,360

 

9,582

 

 

47,942

 

Income (loss) from operations

 

(7,677)

 

17,932

 

 

10,255

 

Net income (loss)

 

  $

(10,212)

 

  $

10,531

 

  $

 

  $

319

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*Exclusive of depreciation and amortization

 

 

 

 

 

 

 

Intercompany

 

 

 

 

 

Broadband

 

Telecom

 

Eliminations

 

Consolidated

 

For the nine months ended September 30, 2010:

 

 

 

 

 

 

 

 

 

Operating revenues from external customers

 

  $

129,514

 

  $

52,339

 

  $

 

  $

181,853

 

Intersegment revenues

 

423

 

15,285

 

(15,708)

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Cost of services and products*

 

75,008

 

17,407

 

(13,644)

 

78,771

 

Customer operations and selling

 

16,886

 

7,320

 

(1,664)

 

22,542

 

General and administrative

 

13,550

 

11,146

 

(400)

 

24,296

 

Depreciation and amortization

 

36,929

 

9,119

 

 

46,048

 

Income (loss) from operations

 

(12,436)

 

22,632

 

 

10,196

 

Net income (loss)

 

  $

(11,071)

 

  $

12,475

 

  $

 

  $

1,404

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*Exclusive of depreciation and amortization

 

 

 

 

 

 

 

 

 

 

 

 

 

 

9.  REGULATORY MATTERS

 

Certain of our interstate telecommunications service rates are subject to regulation by the Federal Communications Commission (“FCC”). Interstate switched and special access rates are established through a SureWest Telephone tariff filed with the FCC.  For interstate common line (“CL”) charges, SureWest Telephone concurs with tariffs filed by the National Exchange Carrier Association (“NECA”).  Intrastate service rates are subject to regulation by state commissions.  Prices for intrastate telecommunications services are established through tariffs or through other

 

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regulatory mechanisms, including service guides in California.  Pending and future regulatory actions may have a material impact on our consolidated financial position and results of operations.

 

FCC Matters

 

Under current FCC rules governing rate making, SureWest Telephone is required to establish rates for its interstate telecommunications services based on projected demand usage for the various services.  SureWest Telephone projects its earnings through the use of annual cost separation studies, which utilize estimated total cost information and projected demand usage. Carriers are required to follow FCC rules in the preparation of these annual studies.  SureWest Telephone determines actual earnings from its interstate rates as actual volumes and costs become known.  The FCC monitors SureWest Telephone’s interstate earnings.

 

California Public Utility Commission (“CPUC”) Matters

 

A CPUC decision in August 2005 allowed SureWest Telephone to continue receiving our $11,500 annual draw from the California High Cost Fund (“CHCF”) on an interim basis pending further CPUC action. The CHCF was previously authorized by the CPUC to offset SureWest Telephone’s intrastate regulated operating expenses on an interim basis.  In August 2006, we requested permission from the CPUC to implement a graduated phase-down of our annual $11,500 interim draw. In September 2007, the CPUC issued Decision 07-09-002 which provides for SureWest Telephone to phase-down its interim annual CHCF draw over a five-year period.  The phase-down of the interim draw began in January 2007, initially reducing the annual $11,500 interim draw to $10,200, and in each subsequent year will be incrementally reduced by $2,040.  In 2010, our interim CHCF draw was $4,080 and for 2011 is $2,040.

 

In an ongoing proceeding relating to the New Regulatory Framework (under which SureWest Telephone has been regulated since 1996), the CPUC adopted Decision 06-08-030 in 2006, which grants carriers broader pricing freedom in the provision of telecommunications services, bundling of services, promotions and customer contracts.  This decision adopted a new regulatory framework, the Uniform Regulatory Framework (“URF”), which among other things (i) eliminates price regulation and allows full pricing flexibility for all new and retail services except basic residential services, which limits increases to $3.25 per year during 2009 and 2010, (ii) allows new forms of bundles and promotional packages of telecommunication services, (iii) allocates all gains and losses from the sale of assets to shareholders and (iv) eliminates almost all elements of rate of return regulation, including the calculation of shareable earnings.  Beginning January 1, 2011, each URF Incumbent Local Exchange Carrier (“ILEC”) is allowed full pricing flexibility for the basic residential rate.  On December 31, 2010, the CPUC issued a ruling to initiate a new proceeding to assess whether, or to what extent, the level of competition in the telecommunications industry is sufficient to control prices for the four largest ILECs in the state, including SureWest Telephone, however this proceeding has been placed on hold.  The CPUC’s actions in this and future proceedings could lead to new rules and an increase in government regulation.

 

In December 2007, the CPUC issued a final decision in a proceeding investigating the continued need for an intrastate access element called the transport interconnection charge (“TIC”).  The final decision capped SureWest Telephone’s intrastate access charges through 2010 and the TIC was eliminated effective January 1, 2011.  As a result of the lost TIC revenue, during the quarter and nine month period ended September 30, 2011 intrastate access revenues decreased $489 and $1,574, respectively.

 

10.  COMMITMENTS AND CONTINGENCIES

 

Litigation, Regulatory Proceedings and Other Contingencies

 

We are subject to a variety of legal proceedings, regulatory proceedings, income tax exposures and claims that arise from time to time in the ordinary course of our business. Although management currently believes that resolving these matters, individually or in the aggregate, will not have a material adverse impact on our financial statements. However, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.  We believe that the most notable regulatory proceedings at the federal and state levels that could have a material impact on our operations are proceedings to alter the structure of intercarrier compensation and to implement universal service reform.  It is not yet possible to determine fully the impact of the related FCC and state proceedings on our operations.

 

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

(Amounts in thousands, except select operating metrics and share and per share amounts)

 

Certain statements included in this report, including that which relates to the impact on future revenue sources and potential sharing obligations of pending and future regulatory orders, continued expansion of the telecommunications network and expected changes in the sources of our revenue and cost structure resulting from our entrance into new communications markets, are forward-looking statements and are made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. These forward looking statements generally are identified by the words “believe”, “expect”, “anticipate”, “estimate”, “intend”, “should”, “may”, “will”, “would”, “will be”, “will continue” or similar expressions. Such forward looking statements involve known and unknown risks, the impact of current economic conditions, uncertainties and other factors that may cause actual results, performance or achievements of SureWest Communications (the “Company”, “we” or “our”) to be different from those expressed or implied in the forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward—looking statements is included in our 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”). We disclaim any intention or obligation to update or revise publicly any forward-looking statements. Management’s Discussion and Analysis (“MD&A”) should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes to the financial statements (“Notes”) as of and for the nine months ended September 30, 2011 included in Item 1 of this Quarterly Report on Form 10-Q.

 

Throughout MD&A, we refer to measures that are not a measure of financial performance in accordance with United States generally accepted accounting principles (“US GAAP” or “GAAP”).  We believe the use of these non-GAAP measures on a consolidated and segment basis provides the reader with additional information that is useful in understanding our operating results and trends. These measures should be viewed in addition to, rather than as a substitute for, those measures prepared in accordance with GAAP. See the Non-GAAP Measures section below for a more detailed discussion on the use and calculation of these measures.

 

Overview

 

We are one of the leading providers of integrated communications services and are the bandwidth leader in the markets we serve.  We provide data, video and voice services to residential and business customers in the greater Sacramento, California (“Sacramento region”) and greater Kansas City, Kansas and Missouri areas (“Kansas City area”). We continue to expand the use of optical fiber in our networks.  We increasingly deploy our services by combining fiber-to-the-home (“FTTH”) and fiber-to-the-node (“FTTN”) facilities with the use of Internet Protocol (“IP”) based communications protocol.  Our advanced telecommunications networks give us a competitive edge that enables us to provide our customers with higher data speeds for Internet service and deploy multiple services at superior quality through our high bandwidth capacity.  Our IP based communication protocol enables us to provide dedicated bandwidth at symmetrical data speeds to each of our customers in the Sacramento region.  We classify our operations in two reportable segments: Broadband and Telecommunications (“Telecom”).

 

Broadband Segment

 

Our Broadband segment generated approximately 76% of our consolidated operating revenues, primarily from subscriptions to our data, video and voice services (“broadband services”) and business services during the nine-month period ended September 30, 2011.  We market our broadband services to residential and business customers, either individually or as part of a bundled package. As of September 30, 2011, our broadband services served approximately 105,800 residential subscribers, of which 83% subscribed to two or more of our broadband services, including 46% that subscribed to all three of our broadband services (“triple play”).  As of September 30, 2011, we had approximately 8,000 business customers. New products and features including Advanced Digital TV (“ADTV”), faster data speeds, increased high definition (“HD”) channels, home networking and Internet security software created enhanced subscriber value for our broadband services. We continue to successfully offset industry-wide declines of operating revenues in the Telecom segment with our long-term strategy to grow our Broadband operations.

 

Our data service can provide high-speed Internet access at symmetrical speeds of up to 50 megabits per second (“Mbps”), depending on the nature of the network facilities that are available, the level of service selected and the geographic market availability.  Our advanced telecommunications networks gives us the ability to offer our customers in many locations both faster and symmetrical data speeds, meaning Internet speeds downstream are the

 

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same as those upstream, than those of our competitors.  Customers can use the faster speeds for such things as enhanced online gaming and faster uploading and downloading of multimedia content such as music, photos and video.  As of September 30, 2011, approximately 63% and 29% of our data customers subscribed to speeds of 5 Mbps and 15 Mbps or greater, respectively.  In the Sacramento region, approximately 40% of our data customers subscribe to plans with speeds at or higher than 15 Mbps.  As of September 30, 2011, approximately 32% of the homes in the areas we serve subscribed to one of our high-speed Internet services.

 

Our video services range from a limited basic service to our newest product offering ADTV, powered by Microsoft® Mediaroom.  Depending on the service selected and subject to geographic market availability, our video service subscribers have access to over 310 channels, including premium and pay-per-view channels (which include concerts, sporting events and movies); video on demand (“VOD”) service (which allows access to a library of movies and the ability to start a selection at any time and to pause, rewind, fast-forward and replay); premium VOD channels, music channels and an interactive, on-screen program guide (which allows the subscriber to navigate the channel lineup, the VOD library and recorded programs).  Digital video subscribers may also subscribe to our advanced services, which consist of high-definition television (“HDTV”), and/or digital video recorders (“DVR”).  Our ADTV product, which is currently available in the Sacramento region only, includes a Whole Home DVR, which allows customers the ability to watch recorded shows on any television in the house, record multiple shows at one time and utilize an intuitive on-screen guide and user interface.  We anticipate the deployment of a Whole Home DVR in the Kansas City area during the first half of 2012.  As of September 30, 2011, approximately 23% of the homes in the areas we serve subscribed to one of our video services.

 

Our Voice over Internet Protocol (“VoIP”) digital phone product (“VoIP phone service”) is available in the Sacramento market, including those customers residing in the Telecom segment service territory.  Customers can select individual services or bundled packages that may include unlimited local calling or unlimited local and domestic long distance calling plans.  Our voice products also include value-added services such as voicemail, call waiting, caller identification and many other calling feature options.  As of September 30, 2011, approximately 19% of the homes in our Sacramento market have subscribed to our VoIP phone service. We also offer traditional circuit-switched voice services in the areas we serve.  Our Broadband segment’s total voice penetration in the markets we serve was approximately 24% as of September 30, 2011.

 

We provide a variety of business communications services to small, medium and large business customers.  The services we offer to our business customers include: fiber-optics-based high-speed Internet, customized data and Ethernet transport services, data center and disaster recovery solutions, traditional landline and VoIP phone services, wireless backhaul and digital TV. Utilizing our existing fiber-optic network, we have successfully secured contracts to serve approximately 390 wireless backhaul access points, primarily in the Sacramento region. We anticipate backhaul revenue will continue to grow as wireless carriers, faced with escalating consumer and business demand for mobile broadband connectivity, are forced to expand and improve their networks, and to replace existing backhaul facilities with new facilities capable of handling more traffic faster.

 

Telecom Segment

 

Our Telecom segment, which operates only in the Sacramento region, offers a broad selection of telecommunications services including traditional circuit-switched voice services, long distance services and a number of lightly-regulated or non-regulated services. Most long distance services are offered by our subsidiary SureWest Long Distance, which is a reseller of long distance services.

 

The Telecom segment provides a variety of business service offerings to small, medium and large business customers, including many services over our advanced fiber network.  The services we offer to our business customers include, but are not limited to customized data and Ethernet transport services, traditional landline and scalable IP communication systems.  Although we have experienced declines in the Telecom segments business customer counts in recent years, we anticipate the Telecom segment’s business customer count will stabilize and begin to trend favorably.

 

The Telecom segment also provides wholesale access services through the use of its network to the Broadband segment, which enables the Broadband segment to offer high-speed Internet, VoIP and video services to some customers within SureWest Telephone’s service area. We anticipate the wholesale access services revenue stream will continue to increase as customers within the Telecom segment service territory continue to demand more broadband services.

 

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Telecom segment revenues have decreased as a percentage of our consolidated revenues over the past several years. During the nine months ended September 30, 2011, the Telecom segment generated 24% of our consolidated revenues, a decrease of 5% compared to the same period in 2010.  The decline in revenues is primarily the result of an industry wide trend of declining circuit-switched voice Revenue-generating units (“RGUs”) and a corresponding reduction in the use of related services. Many customers are choosing to subscribe to our Broadband Digital Phone product instead of the traditional circuit-switched phone service offered by SureWest Telephone.  In addition, the Telecom segment revenues have been impacted by scheduled reductions in the subsidies we receive from governmental regulatory agencies.  We expect the declines in Telecom revenues to flatten over the next two years, as the scheduled phase out of certain Telecom support mechanisms is completed and access line losses ease. The Telecom segment continues to generate the majority of our net income and adjusted free cash flow and remains an important part of our long-term growth strategy to fund the expansion of our Broadband segment.

 

Results of Operations

 

The tables below reflect certain financial data (on a consolidated and segment basis) and select operating metrics for each of our reportable segments as of and for the quarters and nine-month periods ended September 30, 2011 and 2010.

 

Financial Data

 

 

 

Quarter Ended September 30,

 

Nine Months Ended September 30,

 

 

 

 

 

 

$

 

%

 

 

 

 

 

$

 

%

 

 

2011

 

2010

 

Change

 

Change

 

2011

 

2010

 

Change

 

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating revenues (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

$48,018

 

$43,861

 

$ 4,157

 

9

%

 

$ 139,356

 

$ 129,514

 

$ 9,842

 

8

%

Telecom

 

14,979

 

17,256

 

(2,277)

 

(13)

 

 

45,158

 

52,339

 

(7,181)

 

(14)

 

Operating revenues

 

62,997

 

61,117

 

1,880

 

3

 

 

184,514

 

181,853

 

2,661

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from operations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

(1,583)

 

(2,942)

 

1,359

 

46

 

 

(7,677)

 

(12,436)

 

4,759

 

38

 

Telecom

 

5,554

 

7,959

 

(2,405)

 

(30)

 

 

17,932

 

22,632

 

(4,700)

 

(21)

 

Income from operations

 

3,971

 

5,017

 

(1,046)

 

(21)

 

 

10,255

 

10,196

 

59

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

(2,801)

 

(3,082)

 

281

 

9

 

 

(10,212)

 

(11,071)

 

859

 

8

 

Telecom

 

3,444

 

4,486

 

(1,042)

 

(23)

 

 

10,531

 

12,475

 

(1,944)

 

(16)

 

Net income

 

643

 

1,404

 

(761)

 

(54)

 

 

319

 

1,404

 

(1,085)

 

(77)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by operating activities

 

21,255

 

20,082

 

1,173

 

6

 

 

61,189

 

46,509

 

14,680

 

32

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted EBITDA (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

11,621

 

10,008

 

1,613

 

16

 

 

33,351

 

26,616

 

6,735

 

25

 

Telecom

 

9,258

 

11,327

 

(2,069)

 

(18)

 

 

29,478

 

34,115

 

(4,637)

 

(14)

 

Adjusted EBITDA

 

20,879

 

21,335

 

(456)

 

(2)

 

 

62,829

 

60,731

 

2,098

 

3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Free cash flow (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

(6,904)

 

(1,843)

 

(5,061)

 

(275)

 

 

(14,809)

 

(6,040)

 

(8,769)

 

(145)

 

Telecom

 

4,709

 

6,115

 

(1,406)

 

(23)

 

 

13,840

 

15,205

 

(1,365)

 

(9)

 

Corporate

 

(10)

 

(45)

 

35

 

78

 

 

(1,551)

 

(984)

 

(567)

 

(58)

 

Free cash flow

 

(2,205)

 

4,227

 

(6,432)

 

(152)

 

 

(2,520)

 

8,181

 

(10,701)

 

(131)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted free cash flow (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Broadband

 

(404)

 

(1,667)

 

1,263

 

76

 

 

(804)

 

(5,776)

 

4,972

 

86

 

Telecom

 

5,664

 

6,268

 

(604)

 

(10)

 

 

15,725

 

16,226

 

(501)

 

(3)

 

Corporate

 

(10)

 

(45)

 

35

 

78

 

 

(1,551)

 

(984)

 

(567)

 

(58)

 

Adjusted free cash flow

 

5,250

 

4,556

 

694

 

15

 

 

13,370

 

9,466

 

3,904

 

41

 

 

(1)      External customers only.

(2)      A non-GAAP measure. See the Non-GAAP Measures section below for additional information and reconciliation to the most directly comparable GAAP measure.

 

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Select Operating Metrics

 

 

 

As of September 30,

 

 

 

2011

 

2010

 

Change

 

% Change

 

Broadband

 

 

 

 

 

 

 

 

 

 

Total residential subscribers (1)

 

105,800

 

104,000

 

1,800

 

2

    %

 

Broadband residential revenue-generating units (2)

 

242,300

 

235,300

 

7,000

 

3

 

 

Data

 

101,300

 

99,200

 

2,100

 

2

 

 

Video

 

64,900

 

61,200

 

3,700

 

6

 

 

Voice

 

76,100

 

74,900

 

1,200

 

2

 

 

Total business customers (3)

 

8,000

 

7,700

 

300

 

4

 

 

 

 

 

 

 

 

 

 

 

 

 

Telecom

 

 

 

 

 

 

 

 

 

 

Voice revenue-generating units (4)

 

24,200

 

30,700

 

(6,500)

 

(21

)

 

Total business customers (3)

 

7,700

 

8,000

 

(300)

 

(4

)

 

 

(1)   Total residential subscribers are customers who receive one or more residential data, video or voice services from one of our subsidiaries in the Broadband segment.

(2)   We can deliver multiple services to a customer. Accordingly, we maintain statistical data regarding RGUs for video, voice and data, in addition to the number of subscribers. For example, a single customer who purchases video, voice and data services would be reflected as three RGUs.

(3)   Total business customers are customers who receive business data, voice or video services and represent a distinct customer account.

(4)   Voice RGUs are residential customers who subscribe to one or more voice access lines.

 

Consolidated Overview

 

Revenue and Cost Structure

 

Our Broadband segment has grown significantly in recent years and now contributes the majority of our consolidated operating revenues and adjusted EBITDA.  As we maintain our focus on growing the Broadband segment, the Telecom segment remains an important part of our long-term growth strategy and it continues to generate the majority of our net income and adjusted free cash flow. Our long-term strategy remains to continue growing our Broadband operations to counter the industry-wide trend of declines in Telecom revenues.

 

Operating Revenues

 

Operating revenues in the Broadband segment increased $4,157 and $9,842 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010. The increase in Broadband operating revenues was attributed to the continued growth in residential and business services. Broadband residential revenues increased $2,705 and $4,739 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010 as a result of a 3% increase in RGUs and higher pricing for video and data services. The launch of our ADTV video product in the Sacramento market in 2010 also contributed to the growth in residential revenue and RGUs.

 

Broadband business revenues increased $1,578 and $5,368 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010. Business customers increased 4% as of September 30, 2011 compared to the prior year as a result of growth, primarily in the Kansas City market.  The variety of our product offerings and our ability to offer customized service packages to businesses of all sizes contributed to the current year growth in business revenue and will continue to provide us with new opportunities in the commercial market.

 

Utilizing our existing fiber-optic network, we are able to acquire and serve a more diversified business customer base and create new long-term revenue opportunities, such as wireless carrier backhaul and data center services. Wireless carrier backhaul revenue increased $471 and $1,730 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010. Growth in these services is expected to continue to contribute to the increase in business revenue as the demand for wireless data continues to grow. We will continue to

 

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invest in new opportunities as they emerge in order to develop and enhance the broadband infrastructure and the residential and business services we offer, while focusing on the generation of new customers and increasing residential penetration on our existing marketable homes.

 

Operating revenues in the Telecom segment decreased $2,277 and $7,181 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010. Residential services decreased $890 and $3,252 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010 and was largely impacted by our customers’ migration toward alternative communication services, including those offered by our Broadband segment. This migration contributed to a 21% decline in the Telecom segment voice RGUs as of September 30, 2011 compared to 2010.  Business revenues decreased $628 and $758 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010 as a result of a 4% decline in business customers. However, the decline was mitigated by higher pricing for data services, which was implemented during the third quarter of 2010. The decrease in operating revenues for the Telecom segment was also impacted by the scheduled reduction in support received from the California High Cost Fund (“CHCF”) of $510 and $1,530 during the quarter and nine month period ended September 30, 2011, respectively, and the elimination of the transport interconnection charge (“TIC”) as of January 1, 2011 which resulted in a decline in revenue of approximately $489 and $1,574 during the quarter and nine month period ended September 30, 2011, respectively.  See the Regulatory Matters section below for a further discussion regarding the regulatory subsidies we receive.

 

The Telecom segment also provides wholesale access and other services to the Broadband segment, which enables the Broadband segment to offer high-speed Internet, VoIP, video and wireless backhaul services to some customers within SureWest Telephone’s service area. These wholesale services are included as intersegment revenues and expenses in each of the respective segments and eliminated in the consolidated statements of operations.

 

Operating Expenses

 

Consolidated operating expenses, excluding depreciation and amortization, increased $2,796 and $708 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010.

 

The increase in consolidated operating expenses was reduced in part by cost savings realized from the workforce reduction initiative implemented during the quarter ended June 30, 2010 in which approximately 60 positions were eliminated in order to improve operating efficiencies and align our operating costs with the decline in Telecom revenues.  Affected employees were provided a range of benefits and resources, including severance. As a result, severance and other related termination costs of approximately $1,428 were incurred during the nine-month period ended September 30, 2010.  However, the decline in labor costs was offset by severance costs of $1,100, which included share-based compensation expense of $859, incurred as a result of the retirement of an executive officer during the nine-month period ended September 30, 2011.

 

Cost of services and products expense increased $1,894 and $2,581 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010.  Programming and network costs related to providing video and data services continue to increase as a result of an increase in programming fees per subscriber and the growth in residential and business services.  However, the nine-month period ended September 30, 2011 was also largely affected by a reduction in Universal Service Administrative Company (“USAC”) expense resulting from the recovery of universal service fund (“USF”) fees of $1,427 related to 2010 and the quarter ended March 31, 2011. See the Other Adjustments section below for a further discussion regarding this matter.

 

Customer operations and selling expense increased $743 during the quarter and decreased $396 during the nine-month period ended September 30, 2011 compared to the same periods in 2010. Sales and advertising costs increased as a result of a new advertising campaign implemented during the quarter ended September 30, 2011.  However, labor costs, primarily for customer services, declined during the nine-month period ended September 30, 2011 resulting from a reduction in headcount through the workforce reduction initiative implemented in 2010.

 

General and administrative expenses increased $159 during the quarter and decreased $1,477 during the nine-month period ended September 30, 2011 compared to the same periods in 2010 primarily as a result of employee severance costs of $934 incurred during the nine months ended September 30, 2010 related to the workforce reduction initiative and savings in labor costs as a result of the reduction in headcount. Other administrative expenses also declined as a result of continued cost reduction initiatives.  However, these cost savings were offset in part by the severance costs of $1,100 for a retiring officer during the nine-month period ended September 30, 2011.

 

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Our consolidated depreciation and amortization expense increased $130 and $1,894 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010 primarily due to the continued expansion of the network and success-based capital projects undertaken within the residential and business broadband service territories.

 

Income from Operations and Adjusted EBITDA

 

Income from operations decreased $1,046 during the quarter and increased $59 during the nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010.  As described above, income from operations decreased primarily as a result of an increase in programming and network costs as well as additional advertising and promotional expenses related to a new advertising campaign during the current quarter.  Adjusted EBITDA decreased $456 during the quarter and increased $2,098 during the nine-month period ended September 30, 2011 compared to the same periods in 2010.  We continued to maintain positive adjusted EBITDA growth during the nine-month period ended September 30, 2011 by successfully replacing the declines in the Telecom segment with growth in our Broadband segment and through cost savings as a result of the workforce reduction initiative implemented during the second quarter of 2010.

 

Free Cash Flow and Adjusted Free Cash Flow

 

Free cash flow decreased $6,432 and $10,701 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010.  The decrease was largely due to additional capital expenditures related to the expansion of our fiber network during the quarter and nine-month period ended September 30, 2011.  In 2011, we have planned additional capital investments for network expansion which will include the addition of 15,500 fiber marketable homes in the Kansas City area and the upgrade of 6,800 copper homes within the telephone service area of the Incumbent Local Exchange Carrier (“ILEC”) so that they will be video service capable. As of September 30, 2011, we added 9,600 of the planned fiber marketable homes in the Kansas City area and upgraded 5,800 of the planned homes in the ILEC territory.  Adjusted free cash flow, which excludes the capital expenditures for network expansion, increased $694 and $3,904 during the quarter and nine-month period ended September 30, 2011, respectively, compared to the same periods in 2010.  We expect capital expenditures and associated free cash flow to vary quarter to quarter based on the expansion of our fiber network in Kansas City and the resulting opportunities for additional residential and business services growth.

 

Other Adjustments

 

Our subsidiaries provide services to customers for which they are required to contribute to the universal service fund. Each subsidiary collects USF fees from its customers and we remit these amounts to the USAC, the administrator of the Federal USF. SureWest Telephone provides wholesale transport services to SureWest Broadband, which SureWest Broadband resells to its own customers.  The SureWest Broadband voice services are subject to USF fees.  During the quarter ended June 30, 2011, we determined that SureWest Telephone remitted USF fees to USAC relating to the wholesale transport for voice services which it sells to SureWest Broadband for the year ended December 31, 2010 and the quarters ended March 31, 2011 and June 30, 2011.  We also determined that SureWest Broadband had remitted USF fees to USAC relating to the voice services provided to its customers during the same time periods, including those services utilizing SureWest Telephone wholesale transport.  Wholesale transport services provided by SureWest Telephone to SureWest Broadband for the resale as voice services are not subject to USF fees for SureWest Telephone, generally because USF contributions are being collected from the end user customers of SureWest Broadband who use these resold wholesale services.  Accordingly, in June 2011, SureWest Telephone filed an amended remittance form with USAC to recover $906 of the fees paid for the year ended December 31, 2010.  During the quarter ended September 30, 2011, USAC approved our amended filing and the USF fees are being refunded to SureWest Telephone monthly through the first quarter of 2012.  The USF fees of $303 and $329 for the quarters ended March 31, 2011 and June 30, 2011, respectively, will be refunded to SureWest Telephone based on its annual remittance form to be filed with USAC during the first quarter of 2012. In addition, SureWest Broadband recorded a $218 reduction to its USAC expense during the quarter ended June 30, 2011 relating to revised estimates to its interstate traffic that will be included in its annual remittance form to be filed with USAC in the first quarter of 2012.  We expect to receive the refunds from the annual remittance filings during the third quarter of 2012.  For the fees relating to 2010 and the quarter ended March 31, 2011, we recognized a reduction in operating expense

 

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(within costs of services and products) on the condensed consolidated statements of income of $1,427 for the nine-month period ended September 30, 2011.  This resulted in an increase to consolidated net income by $856 ($0.06 per share) for the nine months ended September 30, 2011 and a corresponding receivable of $1,756 on the condensed consolidated balance sheets. We received repayment of $307 from USAC during the third quarter of 2011 for the fees related to 2010 and expect to receive the remaining short-term receivable balance of $1,449 by the end of the third quarter of 2012.

 

Segment Results of Operations

 

Broadband

 

 

 

Quarter Ended September 30,

 

Nine Months Ended September 30,

 

 

 

 

 

 

$

 

%

 

 

 

 

 

$

 

%

 

 

2011

 

2010

 

Change

 

Change

 

2011

 

2010

 

Change

 

Change

Data

 

$ 13,672

 

$ 12,100

 

$ 1,572

 

13

%

 

$ 38,824

 

$ 36,493

 

$ 2,331

 

6

%

Video

 

13,336

 

12,151

 

1,185

 

10

 

 

38,992

 

36,536

 

2,456

 

7

 

Voice