UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

(Mark One)

☒ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2014

or

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________ to ____________________.

Commission File Number:  000-35180

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

☐ Yes   ☒ No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

☐ Yes   ☒  No

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   ☐ 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   ☐ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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 check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ☐ Yes  ☒ No

As of June 30, 2014, the aggregate market value of the Registrant’s common stock was $276,846,291.

There were 22,561,858 shares of the registrant’s common stock outstanding as of the close of business on March 3, 2015.  

 

 

 

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LUMOS NETWORKS CORP.
2014 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

 

 

 

 

 

 

 

 

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Part I

FORWARD-LOOKING STATEMENTS

Any statements contained in this report that are not statements of historical fact, including statements about our beliefs and expectations, are forward-looking statements and should be evaluated as such.  The words “anticipates,” “believes,” “expects,” “intends,” “plans,” “estimates,” “targets,” “projects,” “should,” “may,” “will” and similar words and expressions are intended to identify forward-looking statements. These forward-looking statements are contained throughout this report, for example in “Business,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  Such forward-looking statements reflect, among other things, our current expectations, plans and strategies, and anticipated financial results, all of which are subject to known and unknown risks, uncertainties and factors that may cause our actual results to differ materially from those expressed or implied by these forward-looking statements.  Many of these risks are beyond our ability to control or predict.  All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements contained throughout this report.  Because of these risks, uncertainties and assumptions, you should not place undue reliance on these forward-looking statements.  These risks and other factors include those listed under “Risk Factors” and elsewhere in this report.  Furthermore, forward-looking statements speak only as of the date they are made.  We do not undertake any obligation to update or review any forward-looking information, whether as a result of new information, future events or otherwise.

Item 1.  Business. 

Lumos Networks Corp. Overview

Lumos Networks Corp. (“Lumos Networks,” the “Company,” “we,” “us” or “our”) is a fiber-based bandwidth infrastructure and service provider in the Mid-Atlantic region.  We provide services to carriers and enterprise customers, including healthcare providers, local government agencies, financial institutions, educational institutions, and other enterprises over our approximately 7,800 route-mile fiber network.  Our principal products and services include Multiprotocol Label Switching (“MPLS”) based Ethernet, Metro Ethernet (“Metro E”), Fiber to the Cell site (“FTTC”) wireless backhaul and data transport services, wavelength transport services and IP services.  

We  became an independent, publicly traded company on October 31, 2011, as a result of our spin-off from NTELOS Holdings Corp. (“NTELOS”).  Our common stock has been publicly traded on The NASDAQ Stock Market LLC (“NASDAQ”) under the ticker symbol “LMOS” since November 1, 2011.    We conduct all of our business through our wholly-owned subsidiary Lumos Networks Operating Company and its subsidiaries.  Our principal executive offices are located at One Lumos Plaza, Waynesboro, Virginia 22980.  The telephone number at that address is (540) 946-2000. 

Business Strategy

Our primary objective is to leverage and expand our fiber assets to capture the growing demand for data and mobility services among our carrier and enterprise customers in our marketplace. Our overall strategy is to (i) leverage our fiber network to expand to new fiber to the cell site opportunities; (ii) use our “edge-out” strategy to expand into new adjacent geographic markets to expand our addressable market; (iii) monetize our approximately 7,800 route-mile fiber optic network by selling bandwidth infrastructure services to new and existing carrier and enterprise customers while maintaining a ratio of approximately 80% of our data revenue from on-net traffic; (iv) proactively manage our churn through several initiatives including upgrading existing customers from legacy technologies to carrier Ethernet services and improving network and operational performance; (v) focus on managing resources from the declining legacy voice products into our faster growing and more profitable data products; and (vi) execute our success-based investment strategy to maintain our capital efficiency and expand margins.

Our data segment, which provided approximately 53%  of our total revenue in 2014, represents the main growth opportunity and is the key focal point of our strategy and includes our enterprise data, transport and FTTC product groups.  Given our focus on on-net customers, our data services typically carry higher gross margins than many of our other services.    A significant majority of our capital expenditures and sales force are dedicated to increasing revenue and profit from our data segment.  We believe that a balanced split between enterprise and carrier revenue results in the most effective capital allocation and resulting profitability.  We are focused on taking advantage of increased carrier bandwidth demand, particularly for long-term fiber-to-the-cell site contracts from wireless carriers that are deploying LTE data services, selling into the “edge-out” markets, maximizing the use of our carrier end user distribution channel, connecting our enterprise customers to data centers and improving penetration in existing markets.

Our residential and small business (“R&SB”) and RLEC access segments provided approximately 36% and 11% of our total revenue in 2014, respectively.  Despite declining revenues, we expect the cash flows from these legacy businesses to continue to significantly contribute to funding the capital investment in our growing data segment.  Our R&SB segment includes legacy voice and IP services products targeted to our residential and small business customers.  Our RLEC access segment provides other carriers access to our network within our RLEC territories, primarily through switched access services.  This segment requires limited incremental capital to maintain the underlying assets and delivers reasonably predictable cash flows.  The revenue decline is the result of regulatory actions

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taken to reduce intra-state tariffs, access line loss resulting from residential wireless substitution, technology changes and product replacement of voice service offerings from cable operators in our markets.

The key imperatives for our data growth initiatives are as follows:

Enhance Carrier Ethernet Network and Grow FTTC Revenues 

As demand for FTTC services, greater data transport bandwidth, and guaranteed network stability continues, there is an increasing demand to provide carrier Ethernet networks to our wireless carrier customers and large data transport customers. In 2014, we completed the core construction of an approximately 850-mile dedicated carrier network within our existing fiber network to provide FTTC solutions to multiple large wireless communication providers who operate in our markets.  We connected the first FTTC sites to this dedicated carrier network in 2014 and will continue transitioning our remaining FTTC traffic in 2015.  As of December 31, 2014, we provided FTTC connectivity to 858 cell sites.  We intend to significantly increase FTTC connectivity to cell sites in close proximity to our fiber network over the next several years to capitalize on the growth opportunity in our footprint.  In addition to our initiatives centered on enhancing our network and improving operational performance, we will continue to deliberately and proactively manage our legacy customers from legacy services to our carrier Ethernet services with the intent of reducing churn and improving the customer experience with our services.

Enhance Legacy Enterprise Networks and Grow Enterprise Revenues

As demand for greater data related bandwidth and guaranteed network stability continues to grow within Enterprise services, we continue to invest capital in expanding and shoring up our enterprise networks to accommodate our customer needs. Growing our enterprise revenues using a success-based expansion approach is critical to insuring the desired returns on invested capital are met.  As of December 31, 2014, our 7,800 route-mile fiber network was connected to approximately 1,477 buildings.  We believe there is significant opportunity to compete for opportunities to connect to additional buildings and data centers in close proximity to our existing fiber network.  Our primary sales channels are enterprise-direct and carrier end user.  Our carrier end user channel facilitates the sale of enterprise data traffic for national carrier customers that are within our footprint.  This has the primary benefits of leveraging our existing fiber infrastructure to grow revenue and lowering the likelihood of being overbuilt within our markets.  In addition to our initiatives centered on enhancing our network and improving operational performance, we will continue to deliberately and proactively manage our legacy customers from legacy services to our carrier Ethernet services, and appropriately incent our sales force to focus on renewal of long-term contracts with the intent of reducing churn and improving the customer experience through enhanced services. 

Edge-Out into Key Markets Adjacent to Our Existing Network Footprint

Driven by demand from existing enterprise and carrier customers our edge-out strategy expands our fiber network into new contiguous markets  by leveraging existing and new assets.  Our current edge-out markets are Richmond, VA, Norfolk, VA (including the nearby city of Petersburg and the Hampton Roads area) and Western PA.  In 2014, we added 408 route miles of new fiber to our network, which includes the build out of a critical long haul route in Virginia between the cities of Charlottesville and Richmond.  A second critical long-haul route between Richmond, VA and Ashburn, VA was also substantially complete at the end of 2014.  In 2015, our market expansion plans include adding approximately 665 route miles to our fiber network in the Richmond area and eastward to the key metropolitan areas in and around Norfolk, VA.  This expansion strategy is underpinned by a recently signed long-term fiber-to-the-cell contract with a national U.S. wireless carrier, which will connect nearly 250 new cell sites to our fiber network.    As we edge-out into these new markets, we are able to bring new FTTC carrier customers and enterprise customers onto our fiber networks, thus significantly increasing our addressable market size.    In Western PA, we can leverage our fiber assets to build out metro Ethernet and Ethernet rings.  In 2014, we completed network enhancement projects aimed at enhancing our Western PA network by improving redundancy and enabling carrier Ethernet access. 

Drive Incremental On-Net Data Traffic

Our on-net strategy focuses on driving traffic through our network, thereby increasing profitability.  As our network footprint grows and the bandwidth demand increases, we are able to drive incremental revenue through our existing network with minimal increase in operating expenses or incremental capital expenditures.  We evaluate this on-net approach and the associated capital expenditure against the revenue opportunity and have determined that maintaining approximately 80% of our data revenue from on-net traffic is the most effective use of capital.

Use Disciplined, Success-Based Capital Investment Strategy

We seek to maximize our capital expenditure efficiency by requiring that a significant percentage of our capital investment be tied to specific revenue generating products based on customer commitments, which we refer to as “success-based projects”.  Our success-based capital investment strategy involves maximizing capital expenditure efficiency by pursuing on-net and near-net customer opportunities and maintaining a balanced mix of FTTC and enterprise business.  Our capital investment strategy targets a greater than 15% return on investment and a less than 4-year payback, along with other strategic considerations.

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Business Segments 

We have three reportable business segments, as follows:

Data 

Our data segment includes our enterprise data, transport and FTTC product groups.  We market and sell these services primarily to carriers and enterprise customers, including healthcare providers, state and local government agencies, financial institutions, and educational institutions.  Revenues from our data segment accounted for 52.9%, 50.2% and 43.6% of our total revenue for the years ended December 31, 2014, 2013 and 2012, respectively.  Data product lines are growing at a pace that significantly exceeds our legacy product lines and in aggregate,  they also provide a higher gross margin.  The objective of our data segment is to leverage the ever increasing data bandwidth demands from our enterprise and carrier customers in our existing and expanding addressable markets.

Our data segment operations are based upon both our edge-out and on-net strategies that seek to expand into new markets by maximizing the use of our fiber assets while optimizing capital efficiency and profitability.  In 2014, we continued to re-deploy capital and personnel resources away from our declining legacy product lines towards our growth businesses within our data segment.  Our strategy requires disciplined use of capital expenditures on success-based projects to grow our fiber assets and reach an increasing number of both carrier and enterprise customers.

In addition to the higher gross margins that are characteristic of the data business and our on-net expansion, we have also been able to deliver other enterprise services, such as metro Ethernet transport as a direct result of our expanding network.  We believe our on-net and edge-out strategies, combined with our commitment to customer service, will continue to attract larger customers in our key vertical markets.

We generate growth within our data segment from long-term FTTC contracts from wireless carriers deploying LTE services, improving enterprise penetration within our existing and edge-out markets and providing greater Ethernet bandwidth to enterprise customers.  In 2014, we added 250 FTTC sites, representing a year-over-year increase of approximately 41%, and 133 on-net buildings, representing an increase of approximately 10% year-over-year.  Our sales force is organized into carrier and enterprise teams to effectively pursue the FTTC and enterprise opportunities.  Our ability to sustain or accelerate revenue growth in our data segment depends on our ability to obtain and effectively deploy capital to upgrade and expand our fiber network and implement our FTTC and edge-out plans in a timely and disciplined manner, attract new customers and successfully manage churn downwards through customer retention programs and upgrading existing customers from legacy technologies to carrier Ethernet services.  

R&SB

Our R&SB segment includes the following voice products:  local lines, primary rate interface (“PRI”), long distance, toll and directory advertising and other voice services (excluding voice over IP (“VoIP”) services which are typically provided to enterprise customers and are included in our data segment) and the following IP services products: fiber-to-the-premise broadband XL, DSL, integrated access and video.  These products are sold to residential and small business customers through our competitive local exchange carrier (“CLEC”) and rural local exchange carrier (“RLEC”) networks.  Revenues from our R&SB segment accounted for 35.8%, 38.9% and 44.7% of our total revenue for the years ended December 31, 2014, 2013 and 2012, respectively.  Despite declining revenues, we expect the cash flows from our legacy businesses to continue to significantly contribute to funding the capital investment in our growing data segment.  As of December 31, 2014, we operated approximately 83,400 CLEC lines and approximately 27,250 RLEC telephone access lines, a portion of which are fiber-fed and have IPTV-based video services and broadband Internet access with speeds up to 300Mbps.  We also leverage our existing copper assets to provide video services over copper and DSL services to customers typically in our legacy business.  This segment also includes revenues from switched access and reciprocal compensation services provided to other carriers in our competitive markets.

RLEC Access

Our RLEC access segment provides carrier customers access to our network within our RLEC footprint and primarily includes switched access services.  Revenues from our RLEC access segment accounted for 11.3%, 10.9% and 11.7% of our total revenue for the years ended December 31, 2014, 2013 and 2012, respectively.  A  significant portion of our RLEC access segment revenues are derived from programs funded by regulatory agencies for recovery of lost revenues resulting from intercarrier compensation reform.  We anticipate continuing declines in RLEC access revenues primarily resulting from regulatory actions taken by applicable regulatory authorities as described in the Regulation section below and also due to network grooming activities by carriers. 

For detailed financial information about our business segments, see Note 4 in Part II, Item 8. Financial Statements and Supplementary Data of this Annual Report on Form 10-K, and for a detailed review of our financial performance and results of operations by business segment, see Part II, Item 7.  Managements’ Discussion and Analysis of Financial Condition and Results of Operations of this Annual Report on Form 10-K.

 

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Products and Services

Data Services:

We provide data services to carriers and enterprise customers including healthcare providers, local government agencies, financial institutions, educational institutions, and other enterprises over our fiber network.  Our key data service offerings include the following:

 

 

Residential and Small Business:

 

We provide fiber-to-the-premise Broadband XL and DSL Internet, voice, video and IP services to our residential and small business customers.  Our voice service offerings include local lines, PRI, long distance, toll and directory advertising and other voice services.  Our customers have the option of bundling our voice, broadband and video service offerings.  Our IP-enabled product offerings combine voice and data services over a dedicated broadband facility utilizing VoIP protocols allowing customers dynamically allocated bandwidth to maximize voice and data transmission. VoIP technology also enables advanced features such as simultaneous ring, remote office, business continuity and fixed mobile convergence.  Our IPTV-based video services offer over 300 channels, including 85 high definition channels, video-on-demand and DVR capability.

 

Carrier Access:

 

In addition to our data services, we also provide carrier customers with access to our network within our footprint which primarily includes switched access services.

 

Sales, Marketing and Customer Care

Sales.  We serve our carrier and enterprise customers with our suite of fiber-based data products, which include carrier Ethernet, MPLS, VPN, wavelength and dedicated Internet access.  We have continued to see increased demand for these products across our customer base, particularly as demand for data transport and mobility services grow.  The mission of our sales team is to capitalize on this growing demand by offering customized solutions to our carrier and enterprise customers with a continued focus on expanding within our key vertical markets, which include healthcare, education, financial services and government.  Our technical team plays a significant role in our sales approach in order to focus on selling customized, long-term and secure networking and data solutions. 

Over the course of the last year, we have added experienced leadership to our enterprise sales team, and we continue to look to add specialized talent to our sales teams opportunistically.  Our overall strategy of deliberately and strategically shifting resources from the declining legacy businesses into our data business also extends to our sales and sales engineering teams.  Our sales force is organized into carrier and enterprise teams to effectively pursue opportunities with the focus on capitalizing on the increased bandwidth demand, particularly for long-term FTTC contracts from wireless carriers deploying LTE services, selling into the edge-out markets and improving enterprise penetration within our existing markets.  Over the course of the year, we have more fully developed our carrier end user strategy.  Our carrier sales team uses this alternative sales channel to reach new enterprise customers through strategic

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partnerships with national carriers to provide fiber bandwidth solutions over our network.  We expect that a significant portion of new enterprise sales over time will be initiated through this sales channel.

Our current edge-out markets include Richmond, VA, Norfolk, VA (including the city of Petersburg and the Hampton Roads area) and Western PA.  We employ in-market sales teams to drive revenue growth in these markets.  In 2015, our market expansion plans include adding approximately 665-route miles to our fiber network in the Richmond metropolitan area and eastward to the key metropolitan areas in and around Norfolk, VA.  Our market expansion in these key edge-out markets will significantly increase our addressable market for FTTC and enterprise data and our carrier and enterprise sales teams are rapidly mobilizing to sell into these new markets.  We do not currently expect to generate significant revenue from this expansion until 2016.

Marketing.  Our marketing team is primarily focused on driving revenue growth in our data business, revenue retention in our residential and small business segment and defining the overall customer experience.  During 2014, we completed a robust market analysis in our existing and edge out markets which provided further visibility into our data business growth opportunities. As part of the data growth marketing strategy, we have strategic relationships with on-net data center owners to further penetrate the enterprise segment in our markets.  We also successfully executed on the first phase of a multi-phase customer experience enhancement plan that provides deeper customer data visibility internally and enables proactive management of our top customers’ experience with sales, network, service delivery and customer care resources.

Customer Care.  We differentiate our customer care teams so our customer care representatives can provide the highest level of service by specializing in servicing and supporting data customers and residential and small business customers.  We have instituted a Platinum Care program to provide exceptional service to our top data clients.

Our Network and Platform

We have developed a fiber optic network of long-haul fiber, carrier Ethernet and Ethernet rings located primarily in Virginia and West Virginia, and portions of Pennsylvania, Maryland, Ohio and Kentucky.  As of December 31, 2014, our fiber network spanned approximately 7,800 route miles.

Our integrated fiber transport network allows us to offer a suite of advanced next-generation communications services, including, but not limited to, 100Gbps wavelength services, which provides greater throughput and superior latency performance, multi-site networking, dedicated Internet and MEF 2.0 certified Ethernet solutions, high-speed Internet and VoIP services.  We use a multi-vendor approach, including Cisco, Alcatel-Lucent and Ciena, among others, to deliver high-bandwidth wavelength services directly to end customers as infrastructure for the MPLS Ethernet and high-speed Internet backbone.  Network-to-network interconnection points allow us to engage carrier partners to provide end to end service for carrier and enterprise customers.  We continue to invest in our fiber network to support the deployment of next-generation products and services, expand our addressable market and bring new customers on-net.

In 2014, we initiated several significant network enhancement and upgrade projects including the construction of a new MEF certified Carrier Ethernet MPLS/IP fiber overlay network designed to handle fiber-to-the-cell site traffic within our network.  When complete, the overlay network, totaling approximately 850 route miles, will connect four key markets in our footprint (Pittsburgh, PA, Charleston, WV, Roanoke, VA and Ashburn, VA) and will meet carrier class requirements for fast-rerouting, full redundancy and low latency performance.  We also opened a second network operations center located in Pittsburgh, PA that is compatible with our FTTC all-IP network overlay.  Once fully operational, the new network operations center will provide replication of all traditional functions of our existing network operations center located in Waynesboro, VA, including performance surveillance, repair, upgrade and maintenance of our fiber network and redundancy of our business continuity and disaster recovery functions.  Our parallel network operations centers provide technical surveillance of our network using industry leading network management systems. 

Our local networks consist of central office digital switches, routers, loop carriers and virtual and physical collocations interconnected primarily with fiber facilities. A mix of fiber optic and copper facilities connect our customers with the core network. 

Competition

We compete with incumbent local exchange carriers (“ILECs”),  broadband service providers, incumbent cable operators, and fiber providers and to a lesser extent,  CLECs.  We also face competition from potential future market entrants.  In the last two years, we have seen increasing competition from the cable operators and ILECs for metro-Ethernet services to mid-size businesses.  To remain competitive, we position our company as a customer-focused, leading edge provider with a full portfolio of broadband and IP-based services and a differentiation strategy centered on customizable data solutions.

As a result of the rapid growth in demand for broadband data transport, we expect that our competition will increase from market entrants offering FTTC, metro Ethernet solutions and other high-speed data services, including cable and wireless access.  Our competition includes:

 

As the RLEC for the western Virginia cities of Waynesboro, Clifton Forge and Covington and portions of the Virginia counties of Alleghany, Augusta and Botetourt, we have competition from cable companies and are subject to competition from wireless carriers.  A portion of residential customers moving into our service area do not purchase landline phone service.  Although CLECs have not entered our incumbent markets to compete with us, it is possible that one or more may enter our markets.  To minimize potential competition in the RLEC markets, we offer fiber-to-the-home, DSL, video over copper and a variety of bundled services for broadband, voice and video.

We believe our competitive strengths include our advanced fiber network; our footprint, including contiguous markets, which we believe provides opportunities for growth with a favorable competitive environment relative to first-tier markets; our robust and expanding products and services, including FTTC and metro Ethernet; our disciplined, success-based capital investment strategy aimed at optimizing our capital efficiency and delivering attractive returns; our diverse customer base, our future cash flow visibility from our legacy businesses; and our experienced management team, with deep industry experience and a strong track record of operating and scaling bandwidth infrastructure assets.    

Employees 

As of December 31, 2014, we employed 602 full-time and two part-time employees.  Of these employees, 45 are covered by a collective bargaining agreement that expires June 30, 2017.  We believe that we have good relations with our employees.

Access to Public Filings

We routinely post important information on our website at www.lumosnetworks.com.  Information contained on our website is not incorporated by reference into this annual report on Form 10-K.  We provide public access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed with the U.S. Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934.  These documents may be accessed free of charge on our website at the following address: http://ir.lumosnetworks.com.    These reports are available as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Regulation

The following summary does not describe all present and proposed federal and state legislation and regulations affecting the telecommunications industry.  Some legislation and regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals which could change the manner in which this industry operates.  Neither the outcome of any of these developments, nor their potential impact on us, can be predicted at this time.  Regulation can change rapidly in the telecommunications industry, and such changes may have an adverse effect on us in the future.  See “Risk Factors” elsewhere in this report.

Regulation Overview

Our communications services are subject to varying degrees of federal, state and local regulation.  Under the federal Communications Act, the Federal Communications Commission (“FCC”) has jurisdiction over interstate and international common carrier services.  Under the Telecommunications Act of 1996, the FCC has jurisdiction over certain aspects of local interconnection terms and rates between carriers.

In addition to FCC regulation, our communications services are regulated to different degrees by state public service commissions and by local authorities.  Such local authorities have jurisdiction over public rights-of-way and video and telecommunications franchises.

Our operations are subject to various federal and state laws intended to protect the privacy of customers who subscribe to our services.  The FCC has regulations that place restrictions on the permissible uses that we can make of customer-specific information, known as Customer Proprietary Network Information (“CPNI”), received from subscribers and that govern procedures for release of such information and the Federal Trade Commission’s “Red Flag” rules require that companies develop and implement written Identity Theft Prevention programs.

Federal Regulation of Interconnection and Interexchange Services

The Communications Act requires all common carriers to interconnect on a non-discriminatory basis with other carriers, imposes additional requirements on incumbent local exchange carriers (such as our RLEC’s), and imposes even more comprehensive requirements on the largest ILECs.  The large ILECs are required to provide competitors with physical collocation to allow competitors to place qualifying equipment in ILEC central offices; to unbundle some of their services into unbundled network elements (“UNE”) at “forward looking” rates, permit resale of some of their services, provide access to poles, ducts, conduits and

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rights-of-way, and to establish reciprocal compensation for the transport and termination of local traffic.  The obligations of the large ILECs to provide these network facilities and services could be altered or removed by new legislation, regulations or court order.

ILEC operating entities that serve fewer than 50,000 lines are defined as “rural telephone companies” under the Communications Act and are exempt from the additional requirements applicable to the large ILECs unless and until such exemption is removed by the state regulatory body.  Each of our RLEC operations is considered separately and each has this rural telephone company exemption.   

Intercarrier Compensation Reform    

Intercarrier compensation includes regulated interstate and intrastate access charges that we and other RLECs and CLECs receive from long distance carriers for the origination and termination of long distance calls and reciprocal compensation that interconnected local carriers pay to each other for terminating interconnected local wireline calls.

In 2011, the FCC released a significant order on intercarrier compensation reform.  In the order, the FCC adopted a uniform national bill-and-keep framework (in which carriers do not collect or pay access charges or reciprocal compensation) as the ultimate end state for all telecommunications traffic exchanged between carriers.  The FCC established $2 billion Connect America Fund (CAF) for RLECs and RLECs now receive support principally through the CAF rather than through intercarrier compensation.  The FCC order permitted ILECs to implement a new charge on end users to partially offset the loss in access charge revenues, the Access Recovery Charge (“ARC”), effective July 1, 2012.  The maximum ARC for residential customers is $3 per month after six years.  Multi-line business customers have their Subscriber Line Charge and ARC combined capped at $12.20 per line. On May 23, 2014, the Tenth District Court of Appeals affirmed the FCC’s order, including the establishment of the CAF and the reform of intrastate access and reciprocal compensation.

Our RLECs began charging the ARC and began receiving funding from the CAF on July 1, 2012.  Effective July 1, 2013, our RLECs and CLECs took their rates for most intrastate access to interstate rates. Effective July 1, 2014, our RLECs and CLECS further reduced interstate and intrastate access charges as required by the FCC.

Net Neutrality. 

On January 14, 2014, the Federal Court of Appeals for the District of Columbia struck down the FCC’s  “net neutrality” rules, including the following portions of those rules:

The FCC did not appeal the court order and initiated a new rulemaking on Net Neutrality.  On February 26, 2015 the FCC adopted an order re-classifying Internet service providers as common carriers under Title II of the Federal Communications Act and stating its intention to forbear from much of Title II regulation at this time.  The FCC had not yet released the full text of its order as of the date of this filing.

State Regulation of RLEC, CLEC and Interexchange Services

Most states require wireline telecommunications providers to obtain authority from state regulatory commissions prior to offering common carrier services.  State regulatory commissions generally regulate RLEC rates for intrastate services and RLECs must file tariffs setting forth the terms, conditions and prices for their intrastate services.  Our RLECs are subject to regulation in Virginia by the State Corporation Commission (“SCC”). 

We are certificated as a CLEC in Virginia, West Virginia, Pennsylvania, Maryland, Ohio and Kentucky.  Although we file tariffs covering our CLEC services, our rates for such CLEC services generally fluctuate based on market conditions.

Local Government Authorizations

Certain governmental authorities require permits to open streets for construction and/or telecommunications franchises to install or expand facilities.  Video franchises are also required for our video services.  We obtain such permits and franchises as required.  We hold video franchises in the City of Waynesboro, Botetourt County, City of Lynchburg, City of Staunton (for the Gypsy Hill Development only), Bedford County, Alleghany County, City of Covington, Town of Clifton Forge, and Town of Iron Gate.  All of these localities are in the Commonwealth of Virginia.

Retransmission Consent.

   

Local television stations may require that a video provider obtain “retransmission consent” for carriage of the station’s signal, which can enable a popular local television station to obtain concessions from video providers for the right to carry the station’s signal.

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Item 1A.  Risk Factors.  

RISK FACTORS

The following risk factors and other information included in this Form 10-K should be carefully considered.  The risks and uncertainties described below are not the only ones we face.  Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may adversely impact our business operations.  Our business, financial condition or results of operations could be materially adversely affected by any or all of these risks.

Risks Relating to Our Business: 

Adverse economic conditions may harm our business. 

Economic uncertainty or a lack of economic growth could negatively impact our business results.  Unfavorable economic conditions, including a return to recession or disruptions to the credit and financial markets, could cause customers to slow or delay spending.  If demand for our services decreases, our revenues would be adversely affected and churn may increase.  In addition, during challenging economic times our customers may face issues gaining timely access to sufficient credit, which may impair the ability of our customers to pay for services they have purchased.  Any of the above could have a material effect on our business, financial position, results of operations and cash flows. 

We are also susceptible to risks associated with the potential financial instability of the vendors and third parties on which we rely to provide services or to which we outsource certain functions.  The same economic conditions that may affect our customers could also adversely affect vendors and third parties and lead to significant increases in prices, reduction in quality or the bankruptcy of our vendors or third parties upon which we rely.  Any interruption in the services provided by our vendors or by third parties could adversely affect our business, financial position, results of operations and cash flows.  

We may not be able to successfully implement our strategy and thereby sustain our revenue and cash flow growth.

We must grow our data business and manage the decline in our legacy businesses in order to sustain our revenue and cash flow growth.  We have pursued several growth initiatives including:

Our ability to manage this expansion depends on many factors, including our ability to:

We expect we will require additional capital to fund our strategic growth plan, and if we fail to obtain this capital, we may experience a material adverse effect on our business.  

Our strategic growth plans require a significant amount of capital investment in our fiber network.  Additionally, to remain competitive, we will need to continue to upgrade the technical requirements of our existing network infrastructure and build out our network with advanced fiber technology within our territories which will require a significant investment of capital resources.  Furthermore, we have committed to a significant network expansion project in the Richmond, VA and Norfolk, VA markets

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underpinned by a long-term contract with a major national carrier for FTTC services.  A portion of our planned capital expenditures in 2015 are earmarked to fund these projects; however, the cost or extent of the work could be more significant than anticipated.  Any such unplanned capital expenditures may adversely affect our business, financial condition and operating results. 

Although we refinanced our debt in 2013 on favorable terms and expect to be able to fund our current capital requirements with cash on hand,  marketable securities, cash generated from operations and the use of our revolving credit facility, we expect we will need to obtain additional financing in the future to fund our growth strategy.  There is no assurance that we would be able to secure such financing on terms acceptable to us or at all.  Additional equity financing may dilute our stockholders.

We face substantial competition in our markets; our competitors may have substantial business advantages over us and we may not be able to compete successfully.

We compete with ILECs, broadband service providers, incumbent cable operators, fiber companies and to a lesser extent, CLECs.  As a result of the rapid growth in demand for broadband data, we expect that our competition will increase from market entrants offering FTTC, metro Ethernet solutions and other high-speed data services, including cable and wireless access. Our competition includes ILECs, such as AT&T, Verizon, Frontier, Windstream and Centurylink; national fiber service providers and CLECs, including Level 3 and Zayo, and national and regional cable operators, such as Comcast, Shentel, Cox, Time Warner Cable and Suddenlink.    In addition, due to consolidation and strategic alliances within the telecommunications industry, we cannot predict the number of competitors that will emerge.    Such increased competition from existing and new entities could lead to price reductions, loss of customers, reduced operating margins and/or loss of market share.

Many of our competitors have financial resources, corporate backing, customer bases, marketing programs and brand names that are greater than ours.  Additionally, competitors may charge less than we do for services, causing us to reduce, or preventing us from raising, our fees. 

Network delays or interruptions of service could cause us to lose customers.  

To be successful, we must provide our customers reliable network service.  Some of the risks to our network and infrastructure include:  physical damage to outside plant facilities, power surges or outages; network equipment failures due to aging or other factors;  software defects; human error; disruptions beyond our control, including disruptions caused by terrorist activities or severe weather; and failures in operational support systems.

Furthermore, as the demand for increased bandwidth from our customers has grown and as it continues to grow, our fiber optic network could experience greater data loads that may also result in network interruptions in service and reduced capacity for our customers.  Service interruptions and lack of redundancy could cause us to incur additional expenses and/or issue network outage credits to our customers and may cause us to lose customers.

The telecommunications industry is generally characterized by rapid development and introduction of new technologies; if we are unable to adapt to these rapid changes, we could suffer price reductions, customer losses, reduced operating margins and/or loss of market share. 

The telecommunications industry continues to experience rapid and significant changes in technologies and architectures to deliver new services to customers and to deliver existing services more cost-effectively.  We expect that new technologies will continue to enable advances in our customers’ environments that create new demand drivers.  We believe that our future success will depend in part on our ability to anticipate and respond to the rapidly changing needs and demands of our customers on a timely basis and to compete with our competitors' offerings.  Our failure to obtain and integrate new technologies and applications, and develop new service offerings to meet those customer needs or to keep pace with or exceed the service capabilities of our competitors could impact the breadth of our service portfolio, resulting in less competitive and compelling offerings that could impair our ability to attract and retain customers.  We may be unable to keep pace with competitive offerings without making significant additional capital investments or adversely affecting our margins.

 

Revenue from certain of our more traditional products such as dedicated network services and certain voice services is growing slowly or is declining.  As a result, our overall revenue growth is driven primarily by our Ethernet services and we must continue to develop those and other next generation services in order to continue to grow our revenue.  New product development may be capital intensive and may pressure margins until the new products begin to generate substantial revenue.  New products that are largely software based are increasingly complex and may require more customer support and additional systems development.  In addition to investing in new technologies, we must replace equipment that supports our traditional services as that equipment ages or becomes redundant.  If we do not properly manage this process, including the migration of customers to our newer technologies, we may lose customers and market share, and our margins and returns could be adversely affected.

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Losses or a decrease in usage from certain key customers may result in lower revenues or higher expenses.  

We generated approximately 10% of our operating revenue from AT&T in the year ended December 31, 2014.  In addition, we have substantial business relationships with several other telecommunications carriers.  Our next four largest carrier customers, in the aggregate, accounted for approximately 21% of our operating revenues for the year ended December 31, 2014.  If we were to lose AT&T or one or more of these other carrier customers, our revenues would decline, which could have a material adverse effect on our business, financial condition and operating results. 

We have substantial indebtedness, which could have a negative impact on our financing options and liquidity position.    

On April 30, 2013, Lumos Networks Operating Company, our wholly-owned subsidiary, entered into a $425 million credit facility (the “Credit Facility”).  The Credit Facility consists of a  $100 million senior secured five-year term loan, a $275 million senior secured six-year term loan and a $50 million senior secured five-year revolving credit facility.  Our indebtedness under the Credit Facility was $368.4 million at December 31, 2014 and it carries interest expense of approximately $14 million annually.  On January 2, 2015, we entered into a $28 million senior secured incremental term loan facility under the existing Credit Facility (“Term Loan C”).    

Our indebtedness could adversely affect our financial health and business and future operations by, among other things: 

The ability to make payments on our debt will depend upon our future operating performance, which is subject to general economic and competitive conditions and to financial, business and other factors, many of which we cannot control.  If the cash flows from our subsidiaries’ operating activities are insufficient to service our debt obligations, we may take actions, such as delaying or reducing capital expenditures, attempting to restructure or refinance our debt, selling assets or operations or seeking additional equity capital.  Any or all of these actions may not be sufficient to allow us to service our debt obligations.  Further, we may be unable to take any of these actions on satisfactory terms, in a timely manner or at all. 

Our Credit Facility imposes certain operating and financial restrictions, which may prevent us from capitalizing on business opportunities and taking some corporate actions.  

Our Credit Facility imposes certain operating and financial restrictions on our subsidiaries.  These restrictions generally:

We cannot provide assurance that those covenants will not adversely affect our ability to finance our future operations or capital needs or pursue available business opportunities.  A breach of any of these covenants could result in a default with respect to the Credit Facility.  If a default occurs, our indebtedness under the Credit Facility could be declared immediately due and payable.

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Our RLEC subsidiaries are subject to competition and to regulatory regimes at the state and federal level and consequently face substantial regulatory burdens and uncertainties; regulatory developments will further reduce revenues that we receive from access charges and/or from the federal Universal Service Fund, the Connect America Fund or other fund allocations. 

Our RLECs qualify as rural local telephone companies under the Telecommunications Act and are, therefore, exempt from many of the most burdensome obligations of the Telecommunications Act, such as the obligation to sell unbundled elements of our network to our competitors at “forward-looking” prices that the Telecommunications Act places on larger carriers.  Nevertheless, our RLECs face significant competition, particularly from competitors that do not need to rely on access to our network to reach their customers.  Wireless carriers, cable companies and other VoIP providers are able to compete with our RLECs even though the “rural exemption” under the Telecommunications Act is in place.  If our rural exemption were removed, CLECs could more easily enter our RLECs’ markets.  Moreover, the regulatory environment governing wireline local operations has been, and we believe will likely continue to be, very liberal in its approach to promoting competition and network access. 

Over time, FCC and state regulations have resulted in reducing the switched access and reciprocal compensation revenue of our RLECs.  In 2011, the FCC released an order comprehensively reforming interstate and intrastate intercarrier compensation systems.  In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time.  These FCC pricing reductions commenced on July 1, 2012 and continue through July 1, 2020.  A portion of the access revenue previously received by our RLECs from carriers is being recovered through payments from the FCC’s “Connect America Fund” (“CAF”) and from increases in charges to end user subscribers in the form of rate increases and the FCC’s “Access Recovery Charge.”  Regulatory changes could impact the amount and timing of the revenues received from these funds in the future.  There is no guarantee that we will recover all or a portion of lost revenues resulting from intercarrier compensation system reform or that we will not be subject to further rate reductions in the future.  Furthermore, by accepting government funding, we are subject to audit by the FCC or certain other government agencies that administer the funds and our methodologies or approaches taken to determine the amounts of eligible access revenues or costs could be called into question during an audit. Although we believe our methodologies and approaches are compliant and reasonable, there is no assurance that an audit would not result in a demand for a partial refund or nonpayment of future funding by the respective government agency. 

Lumos Networks and other industry participants are frequently involved in disputes over issues that, if decided adversely to us, could harm our financial and operational prospects. 

We anticipate that we will continue to be subject to risks associated with the resolution of various disputes, lawsuits, arbitrations and proceedings affecting our business.  These issues include the administration and enforcement of existing interconnection agreements and tariffs, the terms of new interconnection agreements, operating performance obligations and intercarrier compensation.  We also may be included in proceedings and arbitrations before state and regulatory commissions, private arbitration organizations, and courts over many issues that will be important to our financial and operation success.  While we believe we have adequate reserves for the probable and estimable losses related to the expected outcomes of our current disputes, the results of these disputes are inherently unpredictable.

The implementation of our business strategy is dependent upon our ability to maintain, expand and update our information technology infrastructure in response to growth and changing business needs.

Our business relies on our data, billing and other operational and financial reporting and business systems.  To effectively implement our business strategy, we will need to continue to maintain and, in some cases, make upgrades to modernize our information technology systems and infrastructure, which can be costly.  Our inability to maintain, expand or upgrade our technology infrastructure could have adverse consequences, which could include service or billing interruptions, the diversion of critical resources and inhibiting our growth plans due to an inability to scale effectively.

In 2013, we initiated a multi-year project to upgrade our internal business processes and systems including financial, provisioning, billing and customer care, which will allow us to scale our back office systems as our business continues to grow.  Our objectives include achieving operating efficiencies, improved customer facing capabilities and streamlined business processes.  If we are unable to successfully implement the systems in a timely manner, we could face delays or disruptions in providing services to or billing our customers or we could incur additional costs, which could have an adverse impact to our financial and operating results.

We are dependent on third-party vendors for our information and billing systems.  Any significant disruption in our relationship with these vendors could increase our costs and affect our operating efficiencies.  

Sophisticated information and billing systems are vital to our ability to monitor and control costs, bill customers, process customer orders, provide customer service and achieve operating efficiencies.  We currently rely on internal systems and third-party vendors to provide all of our information and processing systems.  Some of our billing, customer service and management information systems have been developed by third parties and may not perform as anticipated or the third parties may experience interruptions or other problems delivering these systems.  In addition, our plans for developing and implementing our information and billing systems rely to some extent on the delivery of products and services by third-party vendors.  Our right to use these systems is dependent upon

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license agreements with third-party vendors.  Some of these agreements are cancelable by the vendor, and the cancellation or nonrenewable nature of these agreements could impair our ability to process customer information and/or bill our customers.  Since we rely on third-party vendors to provide some of these services, any switch in vendors could be costly and affect operating efficiencies.

We rely on a limited number of key suppliers and vendors for timely supply of equipment and services relating to our network infrastructure.  If these suppliers or vendors experience problems or favor our competitors, we could fail to obtain sufficient quantities of the products and services we require to operate our businesses successfully.  

We depend on a limited number of key suppliers and vendors for equipment and services relating to our network infrastructure.  If these suppliers experience interruptions or other problems delivering these network components and related software on a timely basis, our subscriber growth and operating results could suffer significantly.  Our initial choice of a network infrastructure supplier can, where proprietary technology of the supplier is an integral component of the network, cause us effectively to be locked into one or a few suppliers for key network components.  As a result, we have become reliant upon a limited number of network equipment manufacturers, including Cisco, Alcatel-Lucent, Ciena and others.  If alternative suppliers and vendors become necessary, we may not be able to obtain satisfactory and timely replacement supplies on economically attractive terms, or at all.

If we fail to extend or renegotiate our collective bargaining agreements with our labor union when they expire, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.  

We are a party to collective bargaining agreements with our labor union, which represented 45 employees as of December 31, 2014.  Although we believe that relations with our employees are satisfactory, no assurance can be given that we will be able to successfully extend or renegotiate our collective bargaining agreements when they expire.  If we fail to extend or renegotiate our collective bargaining agreements, if disputes with our union arise, or if our unionized workers engage in a strike or a work stoppage, we could experience a significant disruption of operations or incur higher ongoing labor costs, either of which could have an adverse effect to the business.  Our collective bargaining agreements expire June 30, 2017.

If we cannot obtain and maintain necessary rights-of-way and access to pole attachments for our network, our operations may be interrupted and we would likely face increased costs.  

We need to obtain and maintain the necessary rights-of-way for our network from governmental and quasi-governmental entities and third parties, such as railroads, utilities, state highway authorities, local governments, transit authorities and private landowners.  We may not be successful in obtaining and maintaining these rights-of-way or obtaining them on acceptable terms.  Some agreements relating to rights-of-way may be short-term or revocable at will, and we cannot be certain that we will continue to have access to existing rights-of-way after the governing agreements are terminated or expire.  If any of our right-of-way agreements were terminated or could not be renewed, we may be forced to remove our network facilities from the affected areas, relocate or abandon our networks.  This would interrupt our operations and force us to find alternative rights-of-way and make unexpected capital expenditures.  In addition, our failure to maintain the necessary rights-of-way, franchises, easements, licenses and permits may result in an event of default under our credit agreement and may subject us to legal complaints or claims.  We may also incur costs resulting from a disruption of service or the relocation of equipment for other carriers that use our network under IRUs granted by us.

Under federal law, we have a right to use the poles, ducts, and conduits of investor-owned utilities (electric and telephone) at regulated rates for our cables, including fiber optic facilities.  Some of the poles we use are exempt from federal regulation because they are owned by utility cooperatives and municipal entities.  If the rates, terms and conditions imposed by utilities are unreasonable, or if the utilities do not allow us access to the poles, ducts, and conduits in a timely manner, our business, financial results or financial condition could suffer.   

Our rights to the use of fiber that are part of our network may be affected by the ability to continue long term contracts and the financial stability of our Indefeasible Rights to Use fiber providers. 

A portion of our services are provided on network fiber facilities licensed or leased from other network service providers through IRUs or similar arrangements.  The facilities under these agreements have remaining terms generally ranging from 5 years to 25 years.  In these agreements, the network owner is responsible for network maintenance for which we pay such network owners.  If our network provider under IRU agreements has financial troubles, it could adversely affect our costs, especially maintenance costs and ability to deliver service.  Also, if our network providers under IRU agreements are unable to obtain and maintain necessary rights-of-way and access to pole attachments for their fiber networks or if they fail to renew or extend our IRUs, our operations may be interrupted and/or we could incur material expenses if we were required to relocate to alternative network assets.

We are dependent upon interconnection agreements with other carriers to reach some of our customer locations.

We have interconnection agreements with the ILEC networks in the markets we serve.  Based on customer growth and our assessment of growth opportunities in these markets, we purchase wholesale voice lines, data circuits and access to collocation facilities under these agreements.  From time to time, we are required to negotiate amendments to, extensions of, or replacements for these

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agreements.  Additionally, we may be required to negotiate new interconnection agreements in order to enter new markets in the future.  We may not be able to successfully negotiate amendments to existing agreements, negotiate new interconnection agreements, renew our existing interconnection agreements, opt in to new agreements or successfully arbitrate replacement agreements for interconnection on terms and conditions acceptable to us.  Our inability to do so would adversely affect our existing operations and opportunities to expand our business in existing and new markets.  If rates became unfavorable or we could no longer access collocation facilities, we could be forced to alter our service delivery which could reduce our customer base.  As the FCC modifies and implements rules related to unbundling of ILEC network elements and collocation of competitive facilities at ILEC central offices, we generally have to renegotiate our interconnection agreements to implement those new or modified rules. 

If interest rates increase, our net income could be negatively affected.

Our long-term debt exposes us to adverse changes in interest rates.  We cannot predict whether interest rates for long-term debt will increase, and thus we cannot assure you that our future interest expense will not have a material adverse effect on our business, financial condition, operating results and cash flows.  We did enter into interest rate swap contracts on 50% of the credit facility through 2015 in order to mitigate this exposure.  

Security breaches to our physical facilities, computer networks, and informational databases, and unauthorized use of, or interference with, our network could disrupt services and result in loss of customer data and customers, and increase our costs.  

The nature of our business necessitates that parts of our network remain in the public domain and as a result it is possible that unauthorized use, interference with, or malicious or unintentional disruptions of our network may occur. In addition, computer viruses, theft, attacks by hackers, or similar disruptive problems may occur.  If hackers gain improper access to our databases, they may be able to steal, publish, delete or modify confidential personal information concerning our subscribers. 

In addition, misuse of our customer information could result in more substantial harm perpetrated by third parties.  This could damage our business and reputation, and result in a loss of customers.  Misuse of our customer information would also subject us to fines by the FCC.  We may incur costs associated with the unauthorized use of our network including administrative and capital costs associated with detecting, monitoring and reducing the incidence of malice and fraud.  Malicious and fraudulent use of our network may impact interconnection costs, capacity costs, legal and administrative costs, fraud prevention costs and payments to other carriers for fraudulent use.  

Our physical facilities may be vulnerable to physical break-ins which may also result in the misuse of our customer information, malicious and fraudulent use of our networks that may impact interconnection costs, capacity costs, legal and administrative costs, fraud prevention costs and payments to other carriers for fraudulent use.

If or when we lose a member or members of our senior management, our business may be adversely affected.  

The success of our business is largely dependent on our senior management team, as well as on our ability to attract and retain other highly qualified technical and management personnel, including talented sales and technical personnel. 

We believe that there is, and will continue to be, intense competition for qualified personnel in the telecommunications industry, and we cannot assure you that we will be able to attract and retain the personnel necessary for the development of our business.  The unexpected loss of key personnel or the failure to attract additional personnel as required could have a material adverse effect on our business, financial condition and operating results.  

Any significant impairment of our goodwill or intangible assets would lead to a decrease in our assets and a reduction in net income. 

As of December 31, 2014, we had goodwill and other intangible assets of approximately $116.2 million (approximately 19% of total assets).  If the impact or the timing of ongoing regulatory reform actions is significantly different than what we anticipate or if there are other regulatory or operating changes to our business, we may be forced to record an impairment charge, which would lead to a decrease in our assets and reduction in net income.  We test goodwill and other indefinite-lived intangible assets for impairment annually or more frequently if events or changes in circumstances indicate an impairment may have occurred.  If the testing performed indicates that impairment has occurred, we are required to record an impairment charge for the difference between the carrying value of the goodwill or indefinite-lived intangible asset and the implied fair value of the asset in the period in which the determination is made.  The testing of goodwill and indefinite-lived intangible assets for impairment requires us to make significant estimates about our future performance and cash flows, as well as other assumptions.  These estimates can be affected by numerous factors, including changes in economic, industry or market conditions, changes in underlying business operations, future reporting unit operating performance, existing or new product market acceptance, changes in competition or changes in technologies.  Any changes in key assumptions, or actual performance compared with those assumptions, about our business and our future prospects or other assumptions could affect the fair value of one or more of the indefinite-lived intangible assets or of the reporting units, resulting in an additional impairment charge.  

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Risks Related to Our Common Stock: 

The shares of our common stock owned by the Quadrangle entities are not freely tradable on The NASDAQ Global Market, and a sale of the shares of our common stock by Quadrangle  would increase the number of shares of our common stock eligible to be freely traded on The NASDAQ Global Market, which could depress the market price of our common stock.

 

As of December 31, 2014, Quadrangle beneficially owned 2,791,898 shares, or approximately 12%, of our outstanding common stock under an existing shelf registration filed with the SEC in 2013.  The shares of common stock subject to the shelf registration were not freely tradable on The NASDAQ Global Market and the sale of Quadrangles remaining shares  would increase the number of shares of our common stock eligible to be freely traded on The NASDAQ Global Market, which could depress the market price of our common stock.

 

The Quadrangle entities have significant influence over our business and could delay, deter or prevent a change of control, change in management or business combination that may not be beneficial to our stockholders and as a result, may depress the market price of our common stock.  

As of December 31, 2014, Quadrangle beneficially owned 2,791,898 shares, or approximately 12%, of our outstanding common stock.  In addition,  two of the eight directors that serve on our board of directors are representatives or designees of Quadrangle.  Pursuant to the terms of our shareholders agreement, with stock ownership below 20% of the voting power of our common stock, Quadrangle currently has the right to designate two directors, who do not need to be independent as defined by the rules of the NASDAQ Stock Market.  If Quadrangle’s ownership falls below 10% they may designate only one director and no directors if their ownership falls below 5%.  The shareholders agreement also provides that one director will be our Chief Executive Officer for so long as he or she is employed by us.

By virtue of the shareholders agreement and such stock ownership and representation on the board of directors, Quadrangle has a significant influence over day-to-day corporate and management policies and all matters submitted to our stockholders, including the election of the directors, and can exercise significant control over our business, policies and affairs.  Such concentration of voting power could have the effect of delaying, deterring or preventing a change of control, change in management or a business combination that might otherwise be beneficial to our stockholders and as a result, may depress the market price of our common stock.

The interests of the Quadrangle entities may not coincide with the interests of a holder of our common stock and because the Quadrangle entities have significant influence over our business, they could cause us to enter into transactions or agreements adverse to the interests of our other stockholders.

 

The interests of the Quadrangle entities may not always coincide with the interests of our other stockholders.  Accordingly, because the Quadrangle entities have significant influence over our business, they could cause us to enter into transactions or agreements adverse to the interests of our other stockholders.

 

In addition, the Quadrangle entities are in the business of making investments in companies and may, from time to time, acquire and hold interests in businesses that compete directly or indirectly with us.  The Quadrangle entities may also pursue, for their own account, acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us.  Additionally, we have specifically renounced in the shareholders agreement any interest or expectancy that the Quadrangle entities will offer to us any investment or business opportunity of which they are aware.

 

Provisions in our charter documents and the General Corporation Law of Delaware could discourage potential acquisition proposals, could delay, deter or prevent a change in control and could limit the price certain investors might be willing to pay for our common stock. 

Certain provisions of the General Corporation Law of Delaware, the state in which we are organized, and our certificate of incorporation and bylaws may inhibit a change of control not approved by our board of directors or changes in the composition of our board of directors, which could result in the entrenchment of current management.  These provisions include:

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A portion of our current investor base may be required to sell our common stock.    

A portion of our common stock is held by index funds tied to broad stock indices in which we are included as a component.  If at any time we are not included as a component in those indices, the corresponding index funds will likely be required to sell their shares of our common stock and the price of our common stock could be depressed by those sales. 

Our certificate of incorporation designates the Court of Chancery of the State of Delaware as the sole and exclusive forum for certain litigation that may be initiated by our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with the Company.

Our certificate of incorporation provides that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of fiduciary duty owed by any of our directors, officers or other employees or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the DGCL or our certificate of incorporation or bylaws, or (iv) any action asserting a claim governed by the internal affairs doctrine.  Our certificate of incorporation further provides that any person or entity purchasing or acquiring any interest in shares of our capital stock shall be deemed to have notice of and to have consented to the provisions described above.  This forum selection provision in our certificate of incorporation may limit our stockholders’ ability to obtain a favorable judicial forum for disputes with the Company.    

Risks Related to Our Business Separation from NTELOS:

If the Distribution does not qualify as a tax-free transaction, tax could be imposed on NTELOS and we may be required to indemnify NTELOS for such tax. 

If the Distribution were not to be tax-free to NTELOS, NTELOS would be required to recognize gain in an amount up to the fair market value of our common stock that NTELOS distributed on the distribution date.   

Under the tax matters agreement entered into between NTELOS and us, we are generally required to indemnify NTELOS against any tax resulting from the Distribution to the extent that such tax resulted from any of the following events (among others): (1) an acquisition of all or a portion of our stock or assets, whether by merger or otherwise, (2) any negotiations, understandings, agreements or arrangements with respect to transactions or events that cause the Distribution to be treated as part of a plan pursuant to which one or more persons acquire, directly or indirectly, stock representing a 50% or greater interest in Lumos Networks, (3) certain other actions or failures to act by us, or (4) any breach by us of certain of our representations or undertakings.  Our indemnification obligations to NTELOS and its subsidiaries, officers and directors are not limited by any maximum amount.   

In connection with our separation from NTELOS, NTELOS will indemnify us for certain liabilities and we will indemnify NTELOS for certain liabilities.  If we are required to indemnify NTELOS, we may need to divert cash to meet those obligations and our financial position could be negatively impacted.  In the case of NTELOS’s indemnity, there can be no assurance that the indemnity will be sufficient to insure us against the full amount of such liabilities, or as to NTELOS’s ability to satisfy its indemnification obligations in the future. 

Pursuant to the separation and distribution agreement and certain other agreements with NTELOS, NTELOS agreed to indemnify us from certain liabilities, and we agreed to indemnify NTELOS for certain liabilities, in each case for uncapped amounts.  Indemnities that we may be required to provide NTELOS are not subject to any cap, may be significant and could negatively impact our business, particularly indemnities relating to our actions that could impact the tax-free nature of the Distribution.  Third-parties could also seek to hold us responsible for any of the liabilities that NTELOS has agreed to retain.  Further, there can be no assurance that the indemnity from NTELOS will be sufficient to protect us against the full amount of such liabilities, or that NTELOS will be able to fully satisfy its indemnification obligations.  Moreover, even if we ultimately succeed in recovering from NTELOS any amounts for which we are held liable, we may be temporarily required to bear these losses ourselves.  Each of these risks could negatively affect our business, results of operations and financial condition.

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Item 1B.  Unresolved Staff Comments.

None.

Item 2.  Properties.

We are headquartered in Waynesboro, Virginia and own offices and facilities in a number of locations within our operating markets.  Our offices and facilities are generally shared by our operating segments. We believe that our current facilities are adequate to meet our needs in our existing markets for the foreseeable future.  The table below provides the location, description and approximate square footage of our significant owned properties.

 

We also lease the following significant properties:

Item 3.  Legal Proceedings.

We are involved in routine litigation in the ordinary course of our business,  including litigation involving disputes relating to our billings to other carriers for access to our network (see Note 13 in Part II, Item 8. Financial Statements and Supplementary Data).  We do not believe that any pending or threatened litigation of which we are aware will have a material adverse effect on our financial condition, results of operations or cash flows.

Item 4.  Mine Safety Disclosures.

Not applicable.

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Part II 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. 

Market Information

Our common stock is traded on the NASDAQ Global Market under the symbol “LMOS.”    On March  3, 2015, the last reported sale price for our common stock was $17.93 per share.

Our common stock has been traded on the NASDAQ Global Market under the symbol “LMOS” since November 1, 2011.  Prior to that time, there was no established public trading market for our common stock.  The following table sets forth the high and low prices per share of our common stock and the cash dividends declared per common share for each of the quarters in 2014 and 2013, which correspond to our quarterly fiscal periods for financial reporting purposes: 

 

 

 

 

 

Stock Performance Graph 

The following indexed line graph indicates our total return to stockholders from November 1, 2011 (the first day our Common Stock began trading on the NASDAQ Global Market) to December 31, 2014, as compared to the total return for the NASDAQ Composite Index and the NASDAQ Telecommunications Index for the same period.  The calculations in the graph assume that $100 was invested on November 1, 2011 in our Common Stock and each index and also assume dividend reinvestment.

Cumulative Total Shareholder Return

Lumos Networks, NASDAQ Composite Index
and NASDAQ Telecommunications Index
(11/1/11 - 12/31/14) 

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Holders

There were approximately 2,900 holders of our common stock on March 3,  2015. 

Dividends

Cash dividends of $0.14 per share were declared and subsequently paid for each of the four quarters in 2014 and 2013.  On March 4, 2015, our board of directors suspended our quarterly dividend in favor of allocating capital to growth opportunities.    

Issuer Purchases of Equity Securities

The Company does not currently have a share repurchase program in effect.  However, from time to time the Company repurchases shares of common stock from employee plan participants for settlement of tax withholding obligations in connection with the vesting of restricted stock grants issued pursuant to the Company’s 2011 Equity and Cash Incentive Plan.  The Company did not repurchase any such shares during the three months ended December 31, 2014.

Credit Agreement

Amounts that can be made available to pay dividends or to repurchase shares are limited by a restricted payment basket in our Credit Agreement.

 

 

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Item 6.  Selected Financial Data

SELECTED HISTORICAL FINANCIAL INFORMATION(1)

 

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

You should read the following discussion of our financial condition in conjunction with our consolidated financial statements and the related notes included herein (Item 8).  This discussion contains forward looking statements that involve risks and uncertainties.  For additional information regarding some of these risks and uncertainties that affect our business and the industry in which we operate, please see “Risk Factors” and “Forward-Looking Statements” elsewhere in this report.

Overview

Lumos Network Corp. (“Lumos Networks,” the “Company,” “we,” “us,” or “our”) is a fiber-based bandwidth infrastructure and service provider in the Mid-Atlantic region.  We provide services to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions and educational institutions over our approximately 7,800 route-mile fiber network.  Our principal products and services include Multiprotocol Label Switching (“MPLS”) based Ethernet, Metro Ethernet (“Metro E”), Fiber to the Cell site (“FTTC”) wireless backhaul and data transport services, wavelength transport services and IP services.  

Our primary objective is to leverage and expand our fiber assets to capture the growing demand for data and mobility services among our carrier and enterprise customers in our marketplace. Our overall strategy is to (i) leverage our fiber network to expand to new fiber to the cell site opportunities; (ii) use our “edge-out” strategy to expand into new adjacent geographic markets to expand our addressable market; (iii) monetize our approximately 7,800 route-mile fiber optic network by selling bandwidth infrastructure services to new and existing carrier and enterprise customers while maintaining a ratio of approximately 80% of our data revenue from on-net traffic; (iv)  proactively manage our churn through several initiatives including upgrading existing customers from legacy technologies to carrier Ethernet services and improving network and operational performance; (v) focus on managing resources from the declining legacy voice products into our faster growing and more profitable data products; and (vi) execute our success-based investment strategy to improve capital efficiency and expand margins.

Business Segments

Our operating segments generally align with our major product and service offerings and coincide with the way that our chief operating decision makers measured performance and allocated resources during 2014.  In 2013, we had three reportable operating segments: strategic data, legacy voice and access.  In January 2014, we completed a business reorganization to further focus on the carrier and enterprise business markets while maintaining our commitment to residential and small business customers.  Accordingly, we revised our reportable segments to reflect the way the chief operating decision makers are managing the business and measuring performance under the new organizational structure.  Our current reportable operating segments are data, residential and small business (“R&SB”) and RLEC access.  Financial information concerning our reportable segments presented below includes restated segment results for the years ended December 31, 2013 and 2012 consistent with the restructuring of our operating segments in 2014.

Our data segment provided 52.9%, 50.2% and 43.8% of our total revenue for the years ended December 31, 2014, 2013 and 2012, respectively.  Revenue for our data segment increased 2.4% for the year ended December 31, 2014, as compared to 2013.  This segment, which includes our enterprise data, transport, and FTTC product groups, represents the main growth opportunity and the key focal point of our strategy.  We market and sell these services primarily to carrier and enterprise customers, including healthcare providers, local government agencies, financial institutions and educational institutions.  These businesses, in the aggregate, typically carry higher gross margins than many of our other product lines.  A majority of our capital expenditures and the focus of our sales force are dedicated to expanding revenue and profit from our data products.  We believe that a balanced split between carrier and enterprise revenue results in the most effective capital allocation and resulting profitability.  Our ability to successfully implement our strategy and thereby sustain or accelerate our revenue growth in our data segment depends on our ability to obtain capital on acceptable terms and implement our “edge out” expansion plans in a timely manner, attract new customers and expand our relationships with existing customers, manage our churn through customer retention programs and by upgrading existing customers from legacy technologies to carrier Ethernet services and respond to competition from other data service providers in existing and new markets. 

The 2.4% growth in our data segment revenues in 2014 was achieved primarily through increases in long-term contracts with large U.S. wireless carriers, as reflected in the addition of 250 fiber to the cell sites in 2014 and the addition of second tenants to existing connected cell towers.  Our sales force is focused on taking advantage of increased carrier bandwidth demand, particularly for long-term fiber to the cell site contracts from wireless carriers that are deploying LTE data services, selling into the “edge out” markets, maximizing the use of our carrier end user distribution channel, connecting our enterprise customers to data centers, and improving penetration in existing markets.  As of December 31, 2014, we had 858 cell towers and 1,477 buildings connected to our fiber network, including 31 data centers.  Our FTTC revenue increased $5.7 million, or 39.7%, as a result of the growth in connected towers.  The growth in FTTC revenues was partially offset by the year-over-year decline in our revenue from data transport products, which have been negatively impacted by network grooming as existing customers redesign their networks and upgrade from time division multiplexing (“TDM”) technology to Ethernet products to improve efficiency.    Revenues from our enterprise data products was essentially flat due to declines in private line and other enterprise data products, primarily as a result of churn from competition from national carriers and cable operators in our markets, that offset growth from metro Ethernet and carrier end user product lines.    

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As we continue to connect additional cell towers to our network and make further progress with implementing our “edge out” strategy in 2015, which includes extending and upgrading our fiber optic network in the key Virginia markets of Richmond and Norfolk and in Western Pennsylvania, we believe that the effect of churn on legacy product lines will begin to be more than offset by revenue from new enterprise customers, FTTC contracts and inter-carrier connectivity.

Our R&SB segment provided 35.8%, 38.9% and 44.6% of revenue for the years ended December 31, 2014, 2013 and 2012, respectively.  This segment includes legacy voice and IP services products targeted to our residential and small business customers.  Revenue declined 10.7% for our R&SB segment in 2014 as compared to 2013 primarily due to the decline in revenues from legacy voice products and CLEC access. This decline is attributable to voice line loss resulting from residential wireless substitution, technology changes and product replacement by competitive voice service offerings from cable operators in our markets. We currently expect aggregate revenue from these businesses will continue to decline.

Our RLEC access segment provided 11.3%, 10.9% and 11.7% of revenue for the years ended December 31, 2014, 2013 and 2012, respectively.  This business requires limited incremental capital to maintain the underlying assets and delivers reasonably predictable cash flows.  However, revenue decline over time is expected due to access line loss and regulatory actions taken to reduce intra-state tariffs by applicable regulatory authorities, principally the FCC and the SCC.  In 2011, the FCC released an order comprehensively reforming its Universal Service Fund (“USF”) and intercarrier compensation systems.  In the order, the FCC determined that interstate and intrastate access charges, as well as local reciprocal compensation, should be eliminated entirely over time.  These FCC pricing reductions commenced on July 1, 2012 and continue through July 1, 2020.  However, a portion of the access revenue previously received from carriers is being recovered through payments from the FCC’s “Connect America Fund” (“CAF”) and from increases in charges to end user subscribers in the form of rate increases and the FCC’s “Access Recovery Charge”.  These new payments and revenues were also effective July 1, 2012.  These actions directly impact the access rates charged by our RLECs, which provide service to the rural Virginia cities of Waynesboro and Covington, and portions of the Virginia counties of Alleghany, Augusta and Botetourt.  Our total revenues derived from cost recovery mechanisms, including the USF and the CAF, were $22.5 million, $16.6 million and $9.8 million for the years ended December 31, 2014, 2013 and 2012, respectively, the majority of which are reported in our RLEC access segment.

Our operating income margins were 25.1%, 22.1%  and 19.9%  for the years ended December 31, 2014, 2013 and 2012, respectively.  Excluding a $10.8 million curtailment gain recognized in 2014 as a result of the discontinuance of certain postretirement medical benefits, our operating income margins were 19.7% in 2014.  Our Adjusted EBITDA margins, as defined below, were 50.0%, 46.4% and 43.0% for the years ended December 31, 2014, 2013 and 2012, respectively.  Excluding the curtailment gain, our Adjusted EBITDA margin was 44.6% for 2014.  The decrease in our Adjusted EBITDA margin for 2014 is primarily due to a decline in operating revenues partially offset by a shift towards higher margin product lines and selling, general and administrative expense reductions.  Our operating income margins are also impacted by increased depreciation expense resulting from our capital investments in our fiber optic network and internal business systems.

Operating Revenues

Our revenues are generated from the following segments: 

Operating Expenses

Our operating expenses are incurred from the following categories: 

Adjusted EBITDA

Adjusted EBITDA, as defined by us, is net income attributable to Lumos Networks Corp. before interest, income taxes, depreciation and amortization, accretion of asset retirement obligations, net income attributable to noncontrolling interests, other income or expenses, equity-based compensation charges, acquisition-related charges, amortization of actuarial gains or losses on retirement plans, employee separation charges, restructuring-related charges, gain or loss on settlements and gain or loss on interest rate swap derivatives. Adjusted EBITDA margin is calculated as the ratio of Adjusted EBITDA, as defined above, to operating revenues.

Adjusted EBITDA is a non-GAAP financial performance measure.  It should not be considered in isolation, as an alternative to, or more meaningful than measures of financial performance determined in accordance with GAAP.  Management believes that Adjusted EBITDA is a standard measure of operating performance and liquidity that is commonly reported in the telecommunications and high speed data transport industry and provides relevant and useful information to investors for comparing performance period to period and for comparing financial performance of similar companies.   Management utilizes Adjusted EBITDA internally to assess its ability to meet future capital expenditure and working capital requirements, to incur indebtedness if necessary, and to fund continued growth.  Management also uses Adjusted EBITDA to evaluate the performance of its business for budget planning purposes and as factors in the Company’s employee compensation programs.

Note 4 – Disclosures About Segments of an Enterprise and Related Information, of the Notes to Consolidated Financial Statements provides a reconciliation of Adjusted EBITDA to Operating Income on a consolidated basis.  

Other Income (Expenses)

Our other income (expenses) are generated (incurred) from interest expense on debt instruments and capital lease obligations, including amortization of debt issuance costs, gains or losses on interest rate swap derivatives and other income or expense, which includes interest income and fees, expenses related to our senior secured credit facility and, as appropriate under the circumstances,  secondary public offering and stock registration costs and write-off of unamortized debt issuance costs. 

Income Taxes

Our income tax expense and effective tax rate increases or decreases based upon changes in a number of factors, including primarily the amount of our pre-tax income or loss, state minimum tax assessments and non-deductible expenses. 

Noncontrolling Interests in Losses (Earnings) of Subsidiaries

We have a  partnership through our RLEC with a 46.3% noncontrolling interest that owns certain signaling equipment and provides services to a number of small RLECs and to TNS (an inter-operability solution provider). 

Results of Operations

Year ended December 31, 2014 compared to year ended December 31, 2013

Operating revenues decreased  $6.0 million, or 2.9%, from 2013 to 2014 resulting from a  decrease in R&SB segment revenues of $8.6 million, partially offset by an increase in data segment revenues of $2.5 million.   The growth in data segment revenues was primarily driven by an increase in FTTC revenue of $5.7 million, which increase was partially offset by declines in transport revenues.    The $8.6 million decline in R&SB segment revenues is due primarily to line loss from legacy voice products. For further details regarding these revenue fluctuations, see “Operating Revenues” below.

Operating income increased $4.6 million from $45.8 million in 2013 to $50.5 million in 2014 due primarily to the $10.8 million curtailment gain related to discontinuance of benefits under the postretirement medical plan referenced above, partially offset by a $4.5 million decrease in gross margin (operating revenues less network access costs) and a $2.9 million increase in depreciation and amortization costs due to capital investment primarily in our fiber network assets.  Variances in the individual line items on the consolidated statements of income are described in the operating expenses section below.

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Adjusted EBITDA was $100.6 million in 2014 compared to Adjusted EBITDA of  $96.3 million in 2013.  Excluding the curtailment gain for the postretirement medical plan, Adjusted EBITDA was $89.9 million for 2014.  The year-over-year decrease in Adjusted EBITDA is primarily attributable to the decline in total operating revenues, as described above and in further detail below.

Net income attributable to Lumos Networks increased $3.8 million from 2013 to 2014. Reflected in these results was a $4.6 million increase in operating income and decrease in other expenses due to the non-recurrence of secondary offering costs and costs associated with the debt refinancing in 2013, offset by an increase in interest expense of $0.7 million (net of changes in the fair value of interest rate swap derivatives) and increase in income tax expense of $2.4 million.

OPERATING REVENUES

The following table identifies our operating revenues by major product group for the years ended December 31, 2014 and 2013:

 

Data.    Data revenues increased $2.5 million, or 2.4%, in 2014.  The overall increase in data revenues is due to growth in contracts with wireless carriers for fiber-to-the-cell site services, partially offset by churn in data transport revenues due to network grooming activities as described below:

R&SB.  Revenue from residential and small business products declined 10.7% in 2014 as compared to 2013.  This decline was primarily due to the continuing churn of legacy voice products due to the increasing use of wireless devices and competition from cable operators in our markets as well as our shift in focus to VoIP services (which is included in data segment revenues).  As of December 31, 2014, we operated approximately 27,250  RLEC telephone access lines and approximately 83,400 competitive voice lines, compared to approximately 28,900 and 95,700, respectively, as of December 31, 2013.  This represents a 5.7% year-over-year decline in RLEC telephone access lines and a 12.9%  year-over-year decline in competitive voice lines.  Growth in fiber-to-the-premise products within our IP services product group such as Broadband XL and IP video was more than offset by declines in revenue from legacy DSL products.  Our total video subscribers increased from 5,034 at December 31, 2013 to 5,352 at December 31, 2014.

RLEC Access.  Revenue from RLEC access increased slightly year-over-year primarily as a result of the recovery of certain additional intrastate access charges from the FCC’s Connect America Fund (“CAF”) discussed in the overview section above, offset by declines in revenues due to the decrease in telephone access lines and intrastate access rate reductions mandated by regulatory rate reform. 

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OPERATING EXPENSES

The following table identifies our operating expenses for the years ended December 31, 2014 and 2013:

 

 

Network Access Costs.  Network access costs decreased $1.5 million, or 3.7%, from the prior year primarily due to network grooming and the overall decrease in voice access lines, partially offset by increases in collocation costs as we expand and enhance our fiber network.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses decreased $12.0 million, or 15.6%, in 2014 as compared to 2013 primarily as a result of a net curtailment gain of approximately $10.8 million recognized in 2014 due to the discontinuance of certain medical benefits under our postretirement medical plan and other reductions in personnel-related costs such as non-cash and incentive compensation and pension-related costs, partially offset by increased salaries and wages.  We also incurred lower rent, repairs and maintenance and operating taxes, which decreases were partially offset by increased advertising and marketing costs and professional fees.

Depreciation and Amortization.  Depreciation and amortization increased $2.9 million, or 6.8%, over 2013.  This net increase is attributable to a $3.5 million increase in depreciation expense, partially offset by a $0.6 million decrease in amortization expense related to customer intangibles for which an accelerated amortization method is applied based on these assets’ estimated pattern of benefits.  The increase in depreciation expense is a result of the year-over-year increase in our depreciable base of assets primarily from capital investment in our network including infrastructure upgrades and fiber to the cell site installations and internal business systems.

The following table identifies our operating expenses by segment for the years ended December 31, 2014 and 2013 and provides a reconciliation from total segment operating expenses to consolidated operating expenses for each period.

 

 

 

Data.  Total operating expenses attributed to our data segment increased $4.3 million, or 8.5%, from 2013 to 2014 due to a $0.2 

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million increase in network access costs, a $2.2 million increase in network operating and engineering costs and a $1.9 million increase in other selling, general and administrative expenses.   The increases in network access and operating costs are directly attributable to our investment of resources in our network operations to support the growth in this segment in 2014 and drive future growth.  The increase in selling, general and administrative costs is primarily attributable to the increase in allocated corporate expenses as the data segment grows in relation to the other segments and the redirection of our sales, marketing, customer service, engineering and other resources to support and grow the data business. 

 

R&SB.  The $3.9 million, or 6.9%, decrease in total operating costs attributed to our R&SB segment is primarily attributable to a $1.7 million decrease in network access costs and a $2.2 million decrease in network operating and engineering costs.  The decrease in network access costs and network operating costs is due to an approximate 11.2% year-over-year decrease in voice lines, as reflected in the decline in segment revenues, network grooming activities and internal reorganization to shift resources away from the legacy businesses to our data segment.  The decrease in selling, general and administrative costs is primarily attributable to the decrease in allocated corporate expenses as the data segment grows and we redirect our sales, marketing, customer service, engineering and other resources away from the legacy businesses to support and grow the data business.

RLEC Access.  Operating costs for the RLEC access segment remained materially consistent with the prior year.

 

OTHER INCOME (EXPENSES) AND INCOME TAXES

The following table summarizes our other income (expenses) and income taxes for the years ended December 31, 2014 and 2013:

 

 

 

Interest Expense.  Interest expense in 2014 and 2013 primarily consists of incurred interest costs associated with our Credit Facility as well as amortization of debt issuance costs.  The year-over-year increase in interest expense of $1.4 million is attributable to the debt refinancing in April 2013, which resulted in a higher outstanding principal balance and a $0.2 million increase in amortization of debt issuance costs in 2014 as compared to 2013 (see Note 5 in Part II, Item 8. Financial Statements and Supplementary Data).

(Gain) Loss on Interest Rate Swap Derivatives.  The Company recognized a gain on interest rate swap derivatives of $0.5 million in 2014 and a loss of $0.1 million for 2013.  These gains and losses are reflective of mark-to-market adjustments to record the liability associated with the interest rate swap derivatives at fair value on the consolidated balance sheets, which is impacted by fluctuations in interest rates and other market factors.

Other Income (Expenses).  Other income of $0.7 million in 2014 primarily consists of interest income earned on marketable securities. Other expenses of $1.6 million for 2013 includes approximately $0.9 million of expense related to unamortized debt issuance costs that were written off in connection with the April 2013 debt refinancing transaction and $0.8 million of administrative, legal and accounting costs associated with the secondary offering of our common stock in November 2013 (see Note 1 in Part II, Item 8. Financial Statements and Supplementary Data).

Income Tax Expense.  Income tax expense for the years ended December 31, 2014 and 2013 was $14.4 million and $12.0 million, respectively, which represents the federal statutory tax rate applied to pre-tax income and the effects of state income taxes and certain non-deductible charges for each period.  Our recurring non-deductible expenses relate primarily to certain non-cash equity-based compensation for 2014 and 2013 and limitations on certain officer compensation for 2013.  The increase in income tax expense was primarily due to an increase in income before taxes.  Our effective tax rate was 40.0% in 2014 as compared to 40.2% in 2013.    

At December 31, 2014, we had unused federal net operating losses (“NOLs”) of approximately  $28.3 million, net of adjustments for unrecognized income tax benefits.  Our NOLs, if not utilized to reduce taxable income in future periods, will expire in varying amounts from 2022 through 2034.  We believe that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets.

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Year ended December 31, 2013 compared to year ended December 31, 2012

Operating revenues increased $0.6 million, or 0.3%, from 2012 to 2013 resulting from an increase in data segment revenues of $13.6 million, largely offset by an aggregate decrease in R&SB and RLEC access segment revenues of $13.0 million.  The growth in data segment revenues was primarily driven by an increase in FTTC revenue of $7.5 million and increases in enterprise data and transport revenues of $3.5 million and $2.6 million, respectively, from 2012 to 2013.  The $13.0 million decline in R&SB and access segment revenues is due primarily to line loss, access rate reductions resulting from regulatory actions, access reconfigurations and network grooming by carriers. For further details regarding these revenue fluctuations, see “Operating Revenues” below.

Operating income increased $4.6 million from $41.2 million in 2012 to $45.8 million in 2013 due to a $5.0 million increase in gross margin (operating revenues less network access costs) and a $2.4 million decrease in selling, general and administrative expenses.  These favorable results were partially offset by an increase in depreciation and amortization costs of $3.4 million due to capital investment primarily in our fiber network assets.  Variances in the individual line items on the consolidated statements of operations are described in the operating expenses section below.

Adjusted EBITDA was $96.3 million in 2013 compared to Adjusted EBITDA of $88.9 million in 2012.  The increase in Adjusted EBITDA is directly attributable to the decrease in operating expenses, as described above and in further detail below.

Net income attributable to Lumos Networks increased $1.4 million from 2012 to 2013 primarily due to a $4.6 million increase in operating income, partially offset by an increase in income taxes of $1.0 million and an increase in interest expense of $2.3 million due to our debt refinancing in 2013.

OPERATING REVENUES

The following table identifies our external operating revenues by business segment for years ended December 31, 2013 and 2012:

 

 

Data.  Our  data segment consists of the enterprise data, transport and FTTC product groups.  Changes in revenue by product group are as follows:

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R&SB.  The 12.5% decline in revenues was primarily due to the churn in voice lines due to product replacement by newer technologies, the increasing use of wireless devices and our shift in focus to VoIP (which is included in data segment revenues) and other data products.    As of December 31, 2013, we operated approximately 28,900 RLEC telephone access lines and 95,700 competitive voice lines, compared to approximately 31,200 and 110,000, respectively, as of December 31, 2012.  This represents a 7.4% year-over-year decline in RLEC telephone access lines and a 13.0% year-over-year decline in competitive voice lines primarily due to competition from cable operators in our markets and wireless substitution.  Growth in revenues from high speed fiber-to-the-premise Broadband XL and video services were more than offset by declines in the legacy DSL products in our IP services product group.

RLEC Access.  The 5.9% decline in access revenues is primarily due to a net 7.4% year-over-year decrease in access lines and rate reductions beginning in July 2012 based on rate actions from regulatory authorities, partially offset by the impact of certain cost recovery programs, as described in the overview section above.

OPERATING EXPENSES

The following table identifies our operating expenses for the years ended December 31, 2013 and 2012:

 

 

Network Access Costs.  Network access costs decreased $4.4 million, or 9.5%, from the prior year primarily due to network grooming and the overall decrease in voice access lines.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses decreased $2.4 million, or 3.1%, in 2013 as compared to 2012.  The decrease is primarily attributable to a non-recurring charge for employee separation benefits of $2.3 million in 2012, a $1.9 million net decrease in salaries, wages and benefits, a $0.5 million decrease in rent and a $0.5 million decrease in amortization of actuarial losses, partially offset by a $2.9 million increase in non-cash compensation expense.  The decreases in employee benefits and rent expense are primarily attributable to the restructuring plan that was completed in December 2012, which included an employee reduction-in-force, consolidation of certain facilities and freezing certain retirement benefits.  The increase in non-cash compensation expense is related to stock-based awards granted in 2013 under employee compensation plans and the accelerated vesting of certain performance-based awards upon attainment of the stock price target in accordance with the terms of the awards.

 

Depreciation and Amortization.  Depreciation and amortization increased $3.4 million, or 8.8%, over 2012.  This net increase is attributable to a $4.8 million increase in depreciation expense partially offset by a $1.3 million decrease in amortization expense related to customer intangibles for which amortization expense is escalated in the early years of the asset lives based on these assets’ estimated pattern of benefit.  The increase in depreciation expense is a result of the year-over-year increase in our depreciable base of assets primarily from capital investment in our network including fiber to the cell site installations.

 

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The following table identifies our operating expenses by segment for the years ended December 31, 2013 and 2012 and provides a reconciliation from total segment operating expenses to consolidated operating expenses for each period.

 

 

Data.  Total operating expenses attributed to our data segment increased $7.0 million, or 16.2%, from 2012 to 2013 due to a $0.4 million increase in network access costs, a $4.8 million increase in network operating and engineering costs and a $1.8 million increase in other selling, general and administrative expenses.   The increases in network access and operating costs are directly attributable to our investment of resources in our network operations to support the 15.0% growth in this segment in 2013 and drive future growth.  The increase in selling, general and administrative costs is primarily attributable to the increase in allocated corporate expenses as the data segment grows in relation to the other segments and the redirection of our sales, marketing, customer service, engineering and other resources to support and grow the data segment.    

R&SB.  The $11.7 million, or 17.3%, decrease in total operating costs attributed to our R&SB segment is driven by a $4.8 million decrease in network access costs, a $5.0 million decrease in network operating and engineering costs and a $1.9 million decrease in other selling, general and administrative expenses.  The decrease in network access costs and network operating costs is due to an approximate 11.8% year-over-year decrease in voice lines, as reflected in the decline in segment revenues, network grooming activities and internal reorganization to shift resources away from the legacy businesses to our data segment.  At the end of 2012, we completed a reduction-in-force of approximately 10% of our employees, which primarily impacted our legacy businesses.

RLEC Access.  The decrease in operating costs allocated to the RLEC access segment of our business of $2.2 million, or 32.4%, is primarily attributable to shifting corporate costs to other segments as the revenue in this segment declines.

 

OTHER INCOME (EXPENSES) AND INCOME TAXES

The following table summarizes our other income (expenses) and income taxes for the years ended December 31, 2013 and 2012:

 

 

 

Interest Expense.  Interest expense in 2013 and 2012 primarily consists of incurred interest costs associated with our Credit Facility as well as amortization of debt issuance costs.  The year-over-year increase in interest expense of $2.3 million is attributable to the debt

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refinancing that closed on April 30, 2013, which resulted in a higher outstanding principal balance (see Note 5 in Part II, Item 8. Financial Statements and Supplementary Data).

Loss on Interest Rate Swap Derivatives.  The Company recognized losses on interest rate swap derivatives of $0.1 million and $1.9 million for 2013 and 2012, respectively.  These losses are reflective of mark-to-market adjustments to record the liability associated with the interest rate swap derivatives at fair value on the consolidated balance sheets, which is impacted by fluctuations in interest rates and other market factors.

Other Income (Expenses).  Other expenses of $1.6 million for 2013 includes approximately $0.9 million of expense related to unamortized debt issuance costs that were written off in connection with the April 30, 2013 debt refinancing transaction and $0.8 million of administrative, legal and accounting costs associated with the secondary offering of our common stock in November 2013 (see Note 1 in Part II, Item 8. Financial Statements and Supplementary Data).

Income Tax Expense.  Income tax expense for the years ended December 31, 2013 and 2012 was $12.0 million and $11.0 million, respectively, which represents the federal statutory tax rate applied to pre-tax income and the effects of state income taxes and certain non-deductible charges for each period.  Our recurring non-deductible expenses relate primarily to certain non-cash equity-based compensation for 2012 and 2013 and limitations on certain officer compensation for 2013 which could recur in future periods.  The increase in income tax expense was primarily due to an increase in income before taxes and nondeductible secondary offering costs incurred in 2013.  Our effective tax rate was 40.2% in 2013 as compared to 40.1% in 2012. 

Quarterly Results

The following table sets forth selected unaudited consolidated quarterly statement of operations data for each of the quarters in 2014 and 2013.  This unaudited quarterly information has been prepared on substantially the same basis as our consolidated financial statements appearing elsewhere in this report and includes all adjustments (consisting of normal recurring adjustments) we believe necessary for a fair statement of the unaudited consolidated quarterly data.  The unaudited consolidated quarterly statement of income data should be read together with the consolidated financial statements and related notes thereto included elsewhere in this report.  The results for any quarter are not necessarily indicative of results for any future period, and you should not rely on them as such.  Certain reclassifications have been made to segment results within revenue and operating expenses for prior interim periods to conform to the current period presentation primarily as a result of the restructuring of our operating segments in 2014.