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Fairpoint Communications 10-Q 2006

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006.

or

o                                 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 333-56365


FairPoint Communications, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

 

13-3725229

(State or Other Jurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer
Identification No.)

521 East Morehead Street, Suite 250
Charlotte, North Carolina

 

28202

(Address of Principal Executive Offices)

 

(Zip Code)

 

(704) 344-8150

(Registrant’s telephone number, including area code)


Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

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

Large accelerated filer o            Accelerated filer o            Non-accelerated filer x

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

As of November 1, 2006, there were 35,113,105 shares of the Registrant’s common stock, par value $0.01 per share, outstanding.

Documents incorporated by reference: None

 




INDEX

 

 

 

Page

PART I. FINANCIAL INFORMATION

 

 

 

Item 1.

 

Financial Statements

 

4

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005

 

4

 

 

 

Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006and 2005

 

5

 

 

 

Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2006 and 2005

 

6

 

 

 

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005

 

7

 

 

 

Notes to Condensed Consolidated Financial Statements

 

8

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

20

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

33

 

Item 4.

 

Controls and Procedures

 

34

 

PART II. OTHER INFORMATION

 

 

 

Item 1.

 

Legal Proceedings

 

35

 

Item 1A.

 

Risk Factors

 

35

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

35

 

Item 3.

 

Defaults Upon Senior Securities

 

36

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

36

 

Item 5.

 

Other Information

 

36

 

Item 6.

 

Exhibits

 

36

 

 

 

Signatures

 

37

 

 

2




PART I—FINANCIAL INFORMATION

Cautionary Note Regarding Forward-Looking Statements

Some statements in this Quarterly Report are known as “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, or the Exchange Act. Forward-looking statements may relate to, among other things:

·       future performance generally,

·       our dividend policy and expectations regarding dividend payments,

·       business development activities,

·       future capital expenditures,

·       future interest expense,

·       distributions from minority investments and passive partnership interests,

·       net operating loss carry forwards,

·       technological developments and changes in the communications industry,

·       financing sources and availability,

·       regulatory support payments,

·       the effects of regulation and competition, and

·       pending litigation.

These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements contained in this Quarterly Report that are not historical facts. When used in this Quarterly Report, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are generally intended to identify forward looking statements. Because these forward-looking statements involve known and unknown risks and uncertainties, there are important factors that could cause actual results, events or developments to differ materially from those expressed or implied by these forward-looking statements, including our plans, objectives, expectations and intentions and other factors discussed in this Quarterly Report and in Exhibit 99.1 to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006. You should not place undue reliance on such forward-looking statements, which are based on the information currently available to us and speak only as of the date on which this Quarterly Report was filed with the Securities and Exchange Commission, or the SEC. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. However, your attention is directed to any further disclosures made on related subjects in our subsequent periodic reports filed with the SEC on Forms 10-K, 10-Q and 8-K and Schedule 14A.

3




Item 1.                        Financial Statements.

Except as otherwise required by the context, references in this Quarterly Report to “FairPoint,” “our company,” “we,” “us,” or “our” refer to the combined business of FairPoint Communications, Inc. and all of its subsidiaries. Except as otherwise required by the context, all references to the “Company” refer to FairPoint Communications, Inc. excluding its subsidiaries.

FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(unaudited)

 

 

 

 

 

(Dollars in thousands)

 

Assets

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

Cash

 

 

$

4,483

 

 

 

$

5,083

 

 

Accounts receivable, net

 

 

30,894

 

 

 

34,985

 

 

Other

 

 

14,179

 

 

 

9,200

 

 

Deferred income tax, net

 

 

21,655

 

 

 

29,190

 

 

Assets of discontinued operations

 

 

 

 

 

90

 

 

Total current assets

 

 

71,211

 

 

 

78,548

 

 

Property, plant, and equipment, net

 

 

248,513

 

 

 

242,617

 

 

Investments

 

 

11,594

 

 

 

39,808

 

 

Goodwill

 

 

493,945

 

 

 

481,343

 

 

Deferred income tax, net

 

 

40,175

 

 

 

47,160

 

 

Deferred charges and other assets

 

 

24,300

 

 

 

18,663

 

 

Total assets

 

 

$

889,738

 

 

 

$

908,139

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

Accounts payable

 

 

$

11,824

 

 

 

$

12,030

 

 

Dividends payable

 

 

13,869

 

 

 

13,789

 

 

Current portion of long-term debt

 

 

705

 

 

 

677

 

 

Demand notes payable

 

 

312

 

 

 

338

 

 

Accrued interest payable

 

 

542

 

 

 

288

 

 

Other accrued liabilities

 

 

16,483

 

 

 

20,808

 

 

Liabilities of discontinued operations

 

 

1,449

 

 

 

2,495

 

 

Total current liabilities

 

 

45,184

 

 

 

50,425

 

 

Long-term liabilities:

 

 

 

 

 

 

 

 

 

Long-term debt, net of current portion

 

 

604,037

 

 

 

606,748

 

 

Deferred credits and other long-term liabilities

 

 

6,770

 

 

 

4,108

 

 

Total long-term liabilities

 

 

610,807

 

 

 

610,856

 

 

Minority interest

 

 

9

 

 

 

10

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

 

 

Common stock

 

 

351

 

 

 

350

 

 

Additional paid-in capital

 

 

543,717

 

 

 

590,131

 

 

Unearned compensation

 

 

 

 

 

(6,475

)

 

Accumulated deficit

 

 

(315,864

)

 

 

(342,635

)

 

Accumulated other comprehensive income, net

 

 

5,534

 

 

 

5,477

 

 

Total stockholders’ equity

 

 

233,738

 

 

 

246,848

 

 

Total liabilities and stockholders’ equity

 

 

$

889,738

 

 

 

$

908,139

 

 

 

See accompanying notes to condensed consolidated financial statements

4




FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(Unaudited)

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(Dollars in thousands)

 

Revenues

 

$

70,700

 

$

66,038

 

$

199,687

 

$

192,909

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Operating expenses, excluding depreciation and amortization

 

40,362

 

38,470

 

112,242

 

106,234

 

Depreciation and amortization

 

12,839

 

12,947

 

39,826

 

39,063

 

Total operating expenses

 

53,201

 

51,417

 

152,068

 

145,297

 

Income from operations

 

17,499

 

14,621

 

47,619

 

47,612

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Net gain (loss) on sale of investments and other
assets

 

64

 

(15

)

14,289

 

(199

)

Interest and dividend income

 

211

 

398

 

3,138

 

1,670

 

Interest expense

 

(9,969

)

(10,026

)

(29,514

)

(36,584

)

Equity in net earnings of investees

 

1,841

 

2,716

 

8,206

 

8,168

 

Other non-operating, net

 

 

 

 

(87,746

)

Total other income (expense)

 

(7,853

)

(6,927

)

(3,881

)

(114,691

)

Income (loss) before income taxes

 

9,646

 

7,694

 

43,738

 

(67,079

)

Income tax (expense) benefit

 

(3,668

)

(3,504

)

(16,965

)

87,915

 

Minority interest

 

(1

)

(1

)

(2

)

(2

)

Net income

 

$

5,977

 

$

4,189

 

$

26,771

 

$

20,834

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

34,651

 

34,550

 

34,618

 

31,043

 

Diluted

 

34,796

 

34,590

 

34,711

 

31,085

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.17

 

$

0.12

 

$

0.77

 

$

0.67

 

Diluted

 

$

0.17

 

$

0.12

 

$

0.77

 

$

0.67

 

 

 

See accompanying notes to condensed consolidated financial statements

5




FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(Dollars in thousands)

 

Net income

 

$

5,977

 

$

4,189

 

$

26,771

 

$

20,834

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Cash flow hedges:

 

 

 

 

 

 

 

 

 

Change in net unrealized gain, net of tax expense of $(3.4) million and $3.3 million as of the three months ended September 30, 2006 and 2005, respectively, and net of tax expense of $0.1 million and $2.2 million for the nine months ended September 30, 2006 and 2005, respectively

 

(5,610

)

5,465

 

57

 

3,699

 

Comprehensive income

 

$

367

 

$

9,654

 

$

26,828

 

$

24,533

 

 

 

See accompanying notes to condensed consolidated financial statements.

6




FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)

 

 

Nine months ended

 

 

 

September 30,

 

 

 

      2006      

 

      2005         

 

 

 

(Dollars in thousands)

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

Net income

 

 

$

26,771

 

 

 

$

20,834

 

 

Adjustments to reconcile net income to net cash provided by operating activities of continuing operations:

 

 

 

 

 

 

 

 

 

Dividends and accretion on shares subject to mandatory redemption

 

 

 

 

 

2,362

 

 

Loss on preferred stock subject to mandatory redemption

 

 

 

 

 

9,899

 

 

Deferred income taxes

 

 

15,159

 

 

 

(97,921

)

 

Amortization of debt issue costs

 

 

1,200

 

 

 

1,458

 

 

Depreciation and amortization

 

 

39,826

 

 

 

39,063

 

 

Loss on early retirement of debt

 

 

 

 

 

77,847

 

 

Minority interest in income of subsidiaries

 

 

2

 

 

 

2

 

 

Income from equity method investments

 

 

(8,206

)

 

 

(8,168

)

 

Net (gain) loss on sale of investments and other assets

 

 

(14,289

)

 

 

199

 

 

Other non cash items

 

 

1,403

 

 

 

1,575

 

 

Changes in assets and liabilities arising from operations:

 

 

 

 

 

 

 

 

 

Accounts receivable and other current assets

 

 

2,838

 

 

 

(1,551

)

 

Accounts payable and accrued expenses

 

 

(4,193

)

 

 

(15,090

)

 

Income taxes

 

 

(520

)

 

 

8,090

 

 

Other assets/liabilities

 

 

(996

)

 

 

226

 

 

Total adjustments

 

 

32,224

 

 

 

17,991

 

 

Net cash provided by operating activities of continuing operations

 

 

58,995

 

 

 

38,825

 

 

Cash flows from investing activities of continuing operations:

 

 

 

 

 

 

 

 

 

Acquisitions of telephone properties, net of cash acquired

 

 

(37,643

)

 

 

(25,730

)

 

Acquisition of investments

 

 

 

 

 

(12

)

 

Net capital additions

 

 

(25,636

)

 

 

(17,905

)

 

Distributions from investments

 

 

7,901

 

 

 

7,309

 

 

Net proceeds from sales of investments and other assets

 

 

43,416

 

 

 

175

 

 

Other, net

 

 

(183

)

 

 

(629

)

 

Net cash used in investing activities of continuing operations

 

 

(12,145

)

 

 

(36,792

)

 

Cash flows from financing activities of continuing operations:

 

 

 

 

 

 

 

 

 

Net proceeds from issuance of common stock

 

 

 

 

 

431,921

 

 

Debt issue and offering costs

 

 

 

 

 

(9,061

)

 

Proceeds from issuance of long-term debt

 

 

94,450

 

 

 

680,709

 

 

Repayments of long-term debt

 

 

(99,583

)

 

 

(883,370

)

 

Repurchase of preferred and common stock

 

 

 

 

 

(129,278

)

 

Payment of fees and penalties associated with early retirement of long term debt

 

 

 

 

 

(61,037

)

 

Payment of deferred transaction fee

 

 

 

 

 

(8,445

)

 

Proceeds from exercise of stock options

 

 

24

 

 

 

184

 

 

Dividends paid to common stockholders

 

 

(41,384

)

 

 

(21,533

)

 

Net cash provided by (used in) financing activities of continuing operations

 

 

(46,493

)

 

 

90

 

 

Cash flows of discontinued operations:

 

 

 

 

 

 

 

 

 

Operating cash flows, net used in

 

 

(957

)

 

 

(610

)

 

Net (decrease) increase in cash

 

 

(600

)

 

 

1,513

 

 

Cash, beginning of period

 

 

5,083

 

 

 

3,595

 

 

Cash, end of period

 

 

$

4,483

 

 

 

$

5,108

 

 

 

See accompanying notes to condensed consolidated financial statements

7




FAIRPOINT COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (Unaudited)

(1)          Organization and Basis of Financial Reporting

The accompanying unaudited condensed financial statements of FairPoint Communications, Inc. and subsidiaries as of September 30, 2006 and for the three and nine month periods ended September 30, 2006 and 2005 have been prepared on the same basis as the audited consolidated financial statements for the year ended December 31, 2005 and, in the opinion of the Company’s management, the unaudited condensed financial statements reflect all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of FairPoint’s results of operations, financial position, and cash flows. The results of operations for the interim periods are not necessarily indicative of the results of operations which might be expected for the entire year. The unaudited condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

(2)          Initial Public Offering and Other Transactions

(a)   General

On February 8, 2005, the Company consummated an initial public offering, or the initial public offering, of 25,000,000 shares of its common stock, par value $0.01 per share, or common stock, at a price to the public of $18.50 per share.

In connection with the initial public offering, the Company entered into a new senior secured credit facility, or the credit facility, with a syndicate of financial institutions, including Deutsche Bank Trust Company Americas, as administrative agent. The credit facility is comprised of a revolving facility in an aggregate principal amount of $100 million (less amounts reserved for letters of credit) and a term facility in an aggregate principal amount of $588.5 million. The revolving facility has a six year maturity and the term facility has a seven year maturity. In addition, in 2005 the Company recorded a $77.8 million loss on early retirement of debt and a $9.9 million loss on redemption of series A preferred stock in connection with the initial public offering. With respect to the $77.8 million loss on early retirement of debt, $16.8 million was recorded for the write-off of existing debt issuance costs and the remaining $61.0 million was fees and penalties.

(b)   Dividends

The Company has adopted a dividend policy under which a substantial portion of the cash generated by the Company’s business in excess of operating needs, interest and principal payments on indebtedness, dividends on future senior classes of capital stock, if any, capital expenditures, taxes and future reserves, if any, would in general be distributed as regular quarterly dividend payments to the holders of its common stock, rather than retained and used for other purposes.

On September 19, 2006, the Company declared a dividend totaling $13.9 million, or $0.39781 per share of common stock, which was paid on October 18, 2006 to holders of record as of October 3, 2006. In 2006, the Company has paid dividends totaling $41.4 million, or $1.19343 per share of common stock.

(3)          Income Taxes

The Company’s accounting policy is to report income tax expense for interim reporting periods using an estimated annual effective income tax rate. However, the effects of significant or unusual items are not

8




considered in the estimated annual effective tax rate. The tax effect of such events is recognized in the interim period in which the event occurs.

For the three months ended September 30, 2006, the Company recorded income tax expense of $3.7 million, resulting in an effective rate of 38.0% compared to 45.5% for the three months ended September 30, 2005.

For the nine months ended September 30, 2006, the Company recorded income tax expense of $17.0 million, resulting in an effective rate of 38.8%. The Company’s effective annual tax rate is estimated to be 38.6% for 2006. For the nine months ended September 30, 2005, the Company recorded an income tax benefit of $87.9 million. The income tax benefit and effective tax rate for the nine months ended September 30, 2005 were primarily impacted by unusual items occurring in 2005. Income tax benefits of $21.9 million were recognized due to the taxable loss for the nine months ended September 30, 2005 which resulted primarily from additional costs associated with the extinguishment of debt. In addition, subsequent to the initial public offering, the Company re-evaluated its expectation of future taxable income and concluded that its future taxable income would be sufficient to fully utilize the benefits of net operating loss, or NOL, carryforwards generated prior to the initial public offering. Therefore, the Company recognized an income tax benefit of $66.0 million from the reversal of the deferred tax valuation allowance that resulted from this re-evaluation of the Company’s expectation of generating future taxable income. The income tax benefit also includes $1.6 million for an adjustment to record the Company’s net deferred tax assets at an expected federal income tax rate of 35%, in anticipation of higher levels of taxable income in subsequent periods.

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which temporary differences become deductible. In addition, management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment, as well as all positive and negative evidence that would affect the recoverability of deferred tax assets. The Company expects that future taxable income will more likely than not be sufficient to recover net deferred tax assets.

(4)          Stock-Based Compensation

Effective on January 1, 2006, the Company adopted the provisions of SFAS 123(R). As a result of this adoption, amounts previously included in stockholders’ equity as unearned compensation are included in additional paid-in capital as of September 30, 2006. At September 30, 2006, the Company had $6.9 million of total unearned compensation cost related to non-vested share-based payment arrangements granted under the Company’s four stock-based compensation plans. That cost is expected to be recognized over a weighted average period of 2.2 years. These stock-based compensation plans are described below. Any future share awards under any of these plans will be made using newly issued shares. Amounts recognized in the financial statements with respect to these plans are as follows (in thousands):

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Amounts charged against income, before income tax benefit

 

 

$

752

 

 

 

$

567

 

 

$

2,036

 

$

1,659

 

Amount of related income tax benefit recognized in income

 

 

283

 

 

 

213

 

 

766

 

624

 

Total net income impact

 

 

$

469

 

 

 

$

354

 

 

$

1,270

 

$

1,035

 

 

9




(a)   1995 Stock Incentive Plan

In February 1995, the Company adopted the FairPoint Communications, Inc. (formerly MJD Communications, Inc.) 1995 Stock Incentive Plan (the 1995 Plan). The 1995 Plan covers officers, directors, and employees of the Company. The Company was allowed to issue qualified or nonqualified stock options to purchase up to 215,410 shares of the Company’s Class A common stock to employees that would vest equally over 5 years from the date of employment of the recipient and are exercisable during years 5 through 10. In 1995, the Company granted options to purchase 161,596 shares at $1.32 per share. No options have been granted since 1995. Effective in February 2005, the Company may no longer grant awards under the 1995 Plan. As of January 1, 2006, only 18,013 options remained outstanding. The life of these options had previously been extended to May 21, 2008. In March 2006 the remaining 18,013 options outstanding were exercised. The intrinsic value of these options on the date of exercise was $230,000, the cash received was $24,000 and the tax benefit was $87,000.

These stock options were granted by the Company prior to becoming a public company and therefore the Company is accounting for these options under the prospective method under SFAS 123(R). The per share weighted average fair value of stock options granted during 1995 was $0.69 on the date of grant using the Black-Scholes option-pricing model. Input variables used in the model included no expected dividend yield, a risk-free interest rate of 6.41%, and an estimated option life of five years. Because the Company was not public on the date of the grant, no assumption as to the volatility of the stock price was made.

(b)   1998 Stock Incentive Plan

In August 1998, the Company adopted the FairPoint Communications, Inc. (formerly MJD Communications, Inc.) Stock Incentive Plan (the 1998 Plan). The 1998 Plan provided for grants of up to 1,317,425 of nonqualified stock options to executives and members of management, at the discretion of the compensation committee of the board of directors. Options vest in 25% increments on the second, third, fourth, and fifth anniversaries of an individual grant. In the event of a change in control, outstanding options will vest immediately. Effective in February 2005, the Company may no longer grant awards under the 1998 Plan.

Pursuant to the terms of the grant, options granted in 1998 and 1999 become exercisable only in the event that the Company is sold, an initial public offering of the Company’s common stock results in the principal shareholders holding less than 10% of their original ownership, or other changes in control, as defined, occur. The number of options that may become ultimately exercisable also depends upon the extent to which the price per share obtained in the sale of the Company would exceed a minimum selling price of $22.59 per share. All options have a term of 10 years from date of grant. For those options granted in 1998 and 1999, the Company will record compensation expense for the excess of the estimated market value of its common stock over the exercise price of the options when and if a sale of the Company, at the prices necessary to result in exercisable options under the grant, becomes imminent or likely. The initial public offering did not trigger exercisability of these options. Upon termination of a plan participant’s employment with the Company, the Company may repurchase all or any portion of the vested options for a cash payment equal to the excess of the fair market value of the shares over the option exercise price. The Company has not previously exercised this right and does not currently intend to exercise this right in the future.

These stock options were granted by the Company prior to becoming a public company and therefore the Company is accounting for these options under the prospective method under SFAS 123(R). The per share weighted average fair value of stock options granted under the 1998 Plan was $58.95 on the date of grant using the Black-Scholes option-pricing model. Input variables used in the model included no expected dividend yield, a risk-free interest rate of 6.52%, and an estimated option life of 10 years. Because the Company was not public on the date of the grant, no assumption as to the volatility of the

10




stock price was made. As of September 30, 2006 and December 31, 2005, options to purchase 832,888 shares of common stock were outstanding with a weighted average exercise price of $10.80.

The following table presents the weighted average price and contractual life information about the various 1998 Plan option groups outstanding at September 30, 2006.

Options outstanding

 

Options exercisable

 

 

 

Number

 

 

 

Aggregate

 

Number

 

 

 

outstanding at

 

Remaining

 

Intrinsic

 

exercisable at

 

Exercise

 

September 30,

 

contractual

 

Value

 

September 30,

 

price

 

2006

 

life (years)

 

(in thousands)

 

2006

 

 

$

9.02

 

 

 

756,332

 

 

 

1.9

 

 

 

6,338

 

 

 

 

 

 

14.46

 

 

 

29,183

 

 

 

2.8

 

 

 

86

 

 

 

 

 

 

36.94

 

 

 

47,373

 

 

 

5.3

 

 

 

 

 

 

 

 

 

 

 

 

 

832,888

 

 

 

 

 

 

 

6,424

 

 

 

 

 

 

The weighted average remaining contractual life for the options outstanding at September 30, 2006 is 2.1 years. The aggregate intrinsic value in the preceding table represents the total pre-tax intrinsic value, based on the closing price of the Company’s stock of $17.40 on September 30, 2006.

(c)   2000 Employee Stock Incentive Plan

In May 2000, the Company adopted the FairPoint Communications, Inc. 2000 Employee Stock Incentive Plan (the 2000 Plan). The 2000 Plan provided for grants to members of management of up to 1,898,521 options to purchase common stock, at the discretion of the compensation committee. During 2002, the Company amended the 2000 Plan to limit the number of shares available for grant to 448,236. In December 2003, the Company amended the 2000 Plan to allow for the grant to members of management of up to 1,898,521 shares of stock units in addition to shares available for stock options. Options granted under the 2000 Plan may be of two types: (i) incentive stock options and (ii) non-statutory stock options. Unless the compensation committee shall otherwise specify at the time of grant, any option granted under the 2000 Plan shall be a non-statutory stock option. Effective in February 2005, the Company may no longer grant awards under the 2000 Plan.

Under the 2000 Plan, unless otherwise determined by the compensation committee at the time of grant, participating employees are granted options to purchase common stock at exercise prices not less than the market value of the Company’s common stock at the date of grant. Options have a term of 10 years from date of grant. Options vest in increments of 10% on the first anniversary, 15% on the second anniversary, and 25% on the third, fourth, and fifth anniversaries of an individual grant. Stock units vest in increments of 33% on each of the third, fourth, and fifth anniversaries of the award. Subject to certain provisions, the Company can cancel each option in exchange for a payment in cash of an amount equal to the excess of the fair market value of the shares over the exercise price for such option. The Company has not previously exercised this right and does not currently intend to exercise this right in the future.

The 2000 Plan stock options and stock units were granted by the Company prior to becoming a public company and therefore the Company is accounting for these awards under the prospective method under SFAS 123(R). The per share weighted average fair value of stock options granted under the 2000 Plan during 2003 was $8.39 on the date of grant using the Black Scholes option-pricing model. Input variables used in the model included no expected dividend yield, a weighted average risk free interest rate of 4.26% in 2003 and an estimated option life of 10 years. Because the Company was not public on the date of grant, no assumption as to the volatility of the stock price was made.

As of September 30, 2006 and December 31, 2005, there were 229,388 and 240,638 options outstanding under the 2000 Plan, respectively. The options outstanding at September 30, 2006 have a weighted average exercise price of $36.94 and remaining contractual life of 6.0 years. As of September 30,

11




2006, 210,499 options with a remaining contractual life of 5.9 years were exercisable with a weighted average exercise price of $36.94. Based upon the fair market value of the stock as of September 30, 2006 of $17.40, these options do not have any intrinsic value.

As of September 30, 2006, there were 24,310 stock units outstanding with a weighted average grant date fair value per share of $32.51. None of these awards were vested as of September 30, 2006 or December 31, 2005.

(d)   2005 Stock Incentive Plan

In February 2005, the Company adopted the FairPoint Communications, Inc. 2005 Stock Incentive Plan (the 2005 Plan). The 2005 Plan provides for the grant of up to 947,441 shares of non-vested stock, stock units and stock options to members of the Company’s board of directors and certain key members of the Company’s management. Shares granted to employees under the 2005 Plan vest over periods ranging from three to four years and certain of these shares pay current dividends. At September 30, 2006, up to 375,343 additional shares of common stock may be issued in the future pursuant to awards authorized under the 2005 Plan.

In March 2006, the Company’s board of directors approved the grant of an additional 100,000 shares to the Company’s chief executive officer. These shares will be granted under the 2005 Plan, or a replacement plan approved by the Company’s shareholders, in two installments of 50,000 shares each on January 1, 2007 and January 1, 2008. These shares are considered to have been granted in March 2006 under SFAS 123(R) at a grant date fair value of $14.02 per share.

In the second quarter of 2006 and the second quarter of 2005, the Company’s board of directors approved an annual award to each of the Company’s non-employee directors of approximately $30,000 in the form of non-vested stock or stock units, at the recipient’s option, issued under the 2005 Plan. The non-vested stock and stock units will vest in four equal quarterly installments on the first day of each of the first four calendar quarters following the grant date and the holders thereof will be entitled to receive dividends from the date of grant, whether or not vested. In the second quarter of 2005, the Company granted 1,870 shares of non-vested stock with a total value at the grant date of approximately $30,000 and 7,480 stock units with a total value at the grant date of approximately $120,000 to the Company’s non-employee directors. In the second quarter of 2006, the Company granted an additional 2,200 shares of non-vested stock with a total value at the grant date of approximately $30,000 and 11,000 stock units with a total value at the grant date of approximately $150,000 to the Company’s non-employee directors. As of September 30, 2006, an additional 1,495 stock units were granted in lieu of dividends on the stock units. In addition, in February 2006, 467 stock units were granted to a newly appointed non-employee director. These stock units vested on April 1, 2006.

The fair value of the awards is calculated as the fair market value of the shares on the date of grant. Beginning on January 1, 2006, the Company adopted the provisions of SFAS 123(R) using the modified prospective method for the awards under the 2005 Plan as all awards were granted subsequent to the Company becoming public. Under this methodology, the Company is required to estimate expected forfeitures related to these grants and, for the non-dividend paying shares, the compensation expense is reduced by the present value of the dividends which were not paid on those shares prior to their vesting.

12




The following table presents information regarding non-vested stock granted to employees under the 2005 Plan during 2006:

 

 

 

 

Weighted

 

 

 

 

 

average grant

 

 

 

Shares

 

date fair value

 

 

 

outstanding

 

per share

 

Non-vested stock

 

 

 

 

 

 

 

 

 

Non-vested at January 1, 2006

 

 

470,029

 

 

 

$

18.13

 

 

Granted

 

 

133,926

 

 

 

15.47

 

 

Vested

 

 

(88,773

)

 

 

18.17

 

 

Forfeited

 

 

(56,369

)

 

 

18.25

 

 

Non-vested at September 30, 2006

 

 

458,813

 

 

 

17.33

 

 

 

(5)          Discontinued Operations and Restructure Charges

In November 2001, the Company announced its plan to discontinue the competitive communications business operations of its wholly owned subsidiary, FairPoint Carrier Services, Inc., or Carrier Services. As a result of the adoption of the plan to discontinue the competitive communications operations, these operating results are presented as discontinued operations.

Net liabilities of discontinued competitive communications operations as of September 30, 2006 and December 31, 2005 were $1.4 million and $2.4 million, respectively. The remaining restructuring accrual at September 30, 2006 was $0.3 million, and is primarily associated with remaining equipment and lease obligations.

(6)          Interest Rate Swap Agreements

The Company assesses interest rate cash flow risk by continually identifying and monitoring changes in interest rate exposures that may adversely impact expected future cash flows and by evaluating hedging opportunities. The Company maintains risk management control systems to monitor interest rate cash flow risk attributable to both the Company’s outstanding and forecasted debt obligations. The risk management control systems involve the use of analytical techniques, including cash flow sensitivity analysis, to estimate the expected impact of changes in interest rates on the Company’s future cash flows.

13




The Company uses variable and fixed-rate debt to finance its operations, capital expenditures and acquisitions. The variable-rate debt obligations expose the Company to variability in interest payments due to changes in interest rates. The Company believes it is prudent to limit the variability of a portion of its interest payments. To meet this objective, the Company enters into interest rate swap agreements to manage fluctuations in cash flows resulting from interest rate risk. These swaps change the variable-rate cash flow exposure on the debt obligations to fixed cash flows. Under the terms of the interest rate swaps, the Company pays a variable interest rate plus an additional payment if the variable rate payment is below a contractual rate, or it receives a payment if the variable rate payment is above the contractual rate. The chart below provides details of each of the Company’s interest rate swap agreements.

Effective Date:

 

 

 

Notional Amount

 

Rate

 

Rate, including
applicable margin

 

Expiration Date

 

February 8, 2005

 

$

130.0 Million

 

3.76

%

 

5.51

%

 

December 31, 2007

 

February 8, 2005

 

$

130.0 Million

 

3.98

%

 

5.73

%

 

December 31, 2008

 

February 8, 2005

 

$

130.0 Million

 

4.11

%

 

5.86

%

 

December 31, 2009

 

April 29, 2005

 

$

50.0 Million

 

4.72

%

 

6.47

%

 

March 31, 2012

 

June 30, 2005

 

$

50.0 Million

 

4.69

%

 

6.44

%

 

March 31, 2011

 

June 30, 2006

 

$

50.0 Million

 

5.36

%

 

7.11

%

 

December 31, 2009

 

 

As a result of these swap agreements, as of September 30, 2006, approximately 90% of the Company’s indebtedness bore interest at fixed rates rather than variable rates. Effective on September 30, 2005, the Company amended the terms of its credit facility. This amendment reduced the effective interest rate margins applicable to the Company’s interest rate swap agreements by 0.25% to 1.75%.

These interest rate swaps qualify as cash flow hedges for accounting purposes. The effect of hedge ineffectiveness on net earnings was insignificant for the three and nine months ended September 30, 2006. At September 30, 2006, the fair market value of these swaps was approximately $8.9 million and has been recorded, net of tax of $3.4 million, as an increase in comprehensive income. Of the $8.9 million, $5.3 million has been included in other current assets and $3.6 million has been included in other long-term assets.

(7)          Investments

The Company has a 7.5% ownership in Orange County Poughkeepsie Limited Partnership, which is accounted for under the equity method. Summary financial information for the partnership follows (in thousands):

 

 

June 30,
2006

 

December 31,
2005

 

Current assets

 

$

14,115

 

 

$

9,812

 

 

Property, plant and equipment, net

 

38,453

 

 

37,516

 

 

Total assets

 

$

52,568

 

 

$

47,328

 

 

Total liabilities

 

$

1,100

 

 

$

432

 

 

Partners’ capital

 

51,468

 

 

46,896

 

 

 

 

$

52,568

 

 

$

47,328

 

 

 

14




 

 

 

Three months
ended
June 30,

 

Nine months
ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenues

 

$

42,588

 

$

43,302

 

$

131,282

 

$

123,946

 

Operating income

 

32,891

 

33,565

 

103,769

 

100,922

 

Net income

 

33,159

 

33,782

 

104,548

 

101,511

 

 

The Company also has other investments in non-marketable securities which are accounted for using the cost and equity methods of accounting. The Company continually monitors all of these investments for possible impairment by evaluating the financial performance of the businesses in which it invests and comparing the carrying value of the investment to quoted market prices (if available), or the fair values of similar investments, which in certain instances, is based on traditional valuation models utilizing multiples of cash flows. When circumstances indicate that a decline in the fair value of the investment has occurred and the decline is other than temporary, the Company records the decline in value as a realized impairment loss and a reduction in the cost of the investment.

On August 4, 2005, the Board of Directors of the Rural Telephone Bank, or RTB, approved the liquidation and dissolution of the RTB. As part of such liquidation and dissolution, all RTB loans were to be transferred to the Rural Utilities Service and all shares of the RTB’s Class A Stock, Class B Stock and Class C Stock were to be redeemed at par value. The Company had no outstanding loans with the RTB but owned 2,477,493 shares of Class B Stock and 24,380 shares of Class C Stock. This liquidation was completed in April 2006, and, as a result, the Company received proceeds of $26.9 million from the RTB liquidation. The Company recorded a gain on this investment of approximately $4.1 million in the second quarter of 2006. Some portion of the proceeds received from the RTB, while not estimable at this time, may be subject to review by regulatory authorities who may require us to record a portion thereof as a regulatory liability. In October 2006, the Company was notified that the state of Washington opened a docket to review the proceeds received by companies from the RTB in that state. At this time, the Company can not determine the impact of this review.

On May 1, 2006, the Company completed the sale of its investment in Southern Illinois Cellular Corp., or SICC, from which it received total proceeds of $16.9 million. As part of this sale, the Company received a portion of total proceeds, approximately $2.1 million, in the form of a dividend. In addition to the dividend income of $2.1 million, the Company recorded a gain on this investment of approximately $10.2 million in the second quarter of 2006. Additional proceeds of approximately $2.6 million will be held in escrow and the Company will not record the gain on this portion of the transaction until the proceeds are received.

(8)          Long Term Debt

Long term debt at September 30, 2006 and December 31, 2005 is shown below:

 

 

September 30,
2006

 

December 31,
2005

 

 

 

(In thousands)

 

Senior secured notes (credit facility), variable rates ranging from 7.25% to 9.25% at September 30, 2006, due 2011 to 2012

 

 

$

600,090

 

 

 

$

602,275

 

 

Senior notes, 11.875%, due 2010

 

 

2,050

 

 

 

2,050

 

 

Senior notes to RTFC, fixed rate, ranging from 8.2% to 9.2%, due 2009 to 2014

 

 

2,602

 

 

 

3,100

 

 

Total outstanding long-term debt

 

 

604,742

 

 

 

607,425

 

 

Less current portion

 

 

(705

)

 

 

(677

)

 

Total long-term debt, net of current portion

 

 

$

604,037

 

 

 

$

606,748

 

 

 

15




The approximate aggregate maturities of long-term debt for each of the five years subsequent to September 30, 2006 are as follows (in thousands):

Year ending September 30,

 

 

 

2007

 

$

705

 

2008

 

743

 

2009

 

307

 

2010

 

2,208

 

2011

 

11,758

 

Thereafter

 

589,021

 

 

 

$

604,742

 

 

The Company has entered into a credit facility consisting of a revolving facility in an aggregate principal amount of up to $100.0 million and a term facility in an aggregate principal amount of $588.5 million. As of September 30, 2006, the Company had borrowed the entire $588.5 million available under the term facility and had $11.6 million outstanding under the revolving facility.

The term facility matures in February 2012 and the revolving facility matures in February 2011. Borrowings bear interest, at the Company’s option, for the revolving facility and for the term facility at either (a) the Eurodollar rate (as defined in the credit facility) plus an applicable margin or (b) the Base rate (as defined in the credit facility) plus an applicable margin. The Eurodollar rate applicable margin and the Base rate applicable margin for loans under the credit facility are 2.0% and 1.0%, respectively. Effective on September 30, 2005, the Company amended its credit facility to reduce the effective interest rate margins on the $588.5 million term facility by 0.25% to 1.75% on Eurodollar loans and to 0.75% for Base rate loans. Interest with respect to Base rate loans is payable quarterly in arrears and interest with respect to Eurodollar loans is payable at the end of the applicable interest period and every three months in the case of interest periods in excess of three months.

The credit facility provides for payment to the lenders of a commitment fee on any unused commitments equal to 0.5% per annum, payable quarterly in arrears, as well as other fees.

The credit facility requires certain mandatory prepayments, including first to prepay outstanding term loans under the credit facility and, thereafter, to repay loans under the revolving facility and/or to reduce revolving facility commitments with, subject to certain conditions and exceptions, 100% of the net cash proceeds the Company receives from any sale, transfer or other disposition of any assets (subject to certain reinvestment election provisions and excluded assets sales), 100% of net casualty insurance proceeds and 100% of the net cash proceeds the Company receives from the issuance of permitted securities and, at certain times if the Company is not permitted to pay dividends, with 50% of the increase in the Company’s Cumulative Distributable Cash (as defined in the credit facility) during the prior fiscal quarter. Reductions to the revolving commitments under the credit facility from the foregoing recapture events will not reduce the revolving commitments under the credit facility below $50.0 million.

The credit facility provides for voluntary prepayments of the revolving facility and the term facility and voluntary commitment reductions of the revolving facility, subject to giving proper notice and compensating the lenders for standard Eurodollar breakage costs, if applicable.

The credit facility requires that the Company maintain certain financial covenants. The credit facility contains customary affirmative covenants, including, without limitation, the following tests: a minimum interest coverage ratio equal to or greater than 3.0:1 and a maximum leverage ratio equal to or less than 5.25:1. The credit facility also contains negative covenants and restrictions, including, among others, with respect to redeeming and repurchasing other indebtedness, loans and investments, additional indebtedness, liens, capital expenditures, changes in the nature of the Company’s business, mergers,

16




acquisitions, asset sales and transactions with the Company’s affiliates. The credit facility restricts the Company’s ability to declare and pay dividends on its common stock as follows:

·       The Company may use its cumulative distributable cash to pay dividends, but may not in general pay dividends in excess of the amount of its cumulative distributable cash. “Cumulative distributable cash” is defined in the credit facility as the amount of “available cash” generated beginning on April 1, 2005 through the end of the Company’s most recent fiscal quarter for which financial statements are available and a compliance certificate has been delivered (a) minus the aggregate amount of dividends paid after July 30, 2005 and the aggregate amount of investments made after April 1, 2005 using such cash, (b) plus the aggregate amount of distributions received from such investments (not to exceed the amount originally invested). “Available cash” is defined in the credit facility as Adjusted EBITDA (a) minus (i) cash interest expense (adjusted for amortization, swap interest and dividends and accretion on series A preferred stock), (ii) scheduled principal payments on indebtedness, (iii) capital expenditures, (iv) investments, (v) cash income taxes, and (vi) non-cash items excluded from Adjusted EBITDA and paid in cash and, (b) plus (i) the cash amount of any extraordinary gains and gains realized on asset sales other than in the ordinary course of business and (ii) cash received on account of non-cash gains and non-cash income excluded from Adjusted EBITDA. “Adjusted EBITDA” is defined in the credit facility as Consolidated Net Income (which is defined in the credit facility and includes distributions from investments) (a) plus the following to the extent deducted from Consolidated Net Income: provision for income taxes, consolidated interest expense, depreciation, amortization, losses on sales of assets and other extraordinary losses, and certain other non-cash items, each as defined, (b) minus gains on sales of assets and other extraordinary gains and all non-cash items increasing Consolidated Net Income.

·       The Company may not pay dividends if a default or event of default under the credit facility has occurred and is continuing or would exist after giving effect to such payment, if the Company’s leverage ratio is above 5.00 to 1.00 or if the Company does not have at least $10 million of cash on hand (including unutilized commitments under the credit facility’s revolving facility).

The credit facility also permits the Company to use available cash to repurchase shares of its capital stock, subject to the same conditions.

The Company may obtain letters of credit under the revolving facility to support obligations of the Company and/or obligations of its subsidiaries incurred in the ordinary course of business in an aggregate principal amount not to exceed $10.0 million and subject to limitations on the aggregate amount outstanding under the revolving facility. As of September 30, 2006, a letter of credit had been issued for $1.4 million.

The credit facility is guaranteed, jointly and severally, subject to certain exceptions, by all first tier subsidiaries of the Company. The Company has provided to Deutsche Bank Trust Company Americas, as collateral agent for the benefit of the lenders under the credit facility and certain hedging creditors under permitted hedging agreements, collateral consisting of (subject to certain exceptions) 100% of the Company’s equity interests in the subsidiary guarantors and certain other intermediate holding company subsidiaries. Newly acquired or formed direct or indirect subsidiaries of the Company which own equity interests of any subsidiary that is an operating company will be required to provide the collateral described above.

17




The credit facility contains customary events of default, including but not limited to, failure to pay principal, interest or other amounts when due, breach of covenants or representations, cross-defaults to certain other indebtedness in excess of specified amounts, judgment defaults in excess of specified amounts, certain ERISA defaults, the failure of any guaranty or security document supporting the credit facility and certain events of bankruptcy and insolvency.

(9)          Earnings Per Share

Earnings per share has been computed in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding for the period. Except when the effect would be anti-dilutive, the diluted earnings per share calculation calculated using the treasury stock method includes the impact of stock units, shares of non-vested common stock and shares that could be issued under outstanding stock options. For the three and nine months ended September 30, 2006 and September 30, 2005, diluted weighted average shares of common stock outstanding included 144,760 and 92,881 shares, respectively, associated with outstanding stock options and non-vested stock and stock units.

The number of potential shares of common stock excluded from the calculation of diluted net income per share, prior to the application of the treasury stock method, is as follows (in thousands):

 

 

Three months
ended
September 30,

 

Nine months
ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Contingent stock options

 

833

 

833

 

833

 

833

 

Shares excluded as effect would be anti-dilutive:

 

 

 

 

 

 

 

 

 

Stock options

 

229

 

242

 

229

 

241

 

Restricted stock

 

432

 

452

 

482

 

471

 

Restricted stock units

 

28

 

30

 

36

 

34

 

Total

 

1,522

 

1,557

 

1,580

 

1,579

 

 

(10)   Subsequent Event

On October 26, 2006, the Company announced a reorganization of its customer sales and services operations. The reorganization will result in additional charges to income from operations of approximately $0.3 million in the fourth quarter of 2006.

(11)   Acquisitions

On August 17, 2006, the Company completed the purchase of Unite Communications Systems, Inc., or Unite, for approximately $11.5 million (or $8.9 million net of cash acquired and debt assumed), subject to adjustment. The Company incurred acquisition costs of $40,000. Unite owns ExOp of Missouri, Inc., which is a facilities-based voice, data and video service provider located outside of Kansas City, Missouri. Unite serves approximately 4,200 access lines in Kearney and Platte City, Missouri.

The Unite acquisition has been accounted for using the purchase method of accounting for business combinations and, accordingly, the acquired assets and liabilities have been recorded at their estimated fair values as of the date of acquisition, and its results of operations have been included in the Company’s consolidated financial statements from the date of acquisition. Based upon the Company’s preliminary purchase price allocation, subject to final determination of the working capital adjustment and final settlement of an escrow (for potential contingent liabilities), the excess of the purchase price and acquisition costs over the fair value of the net identifiable assets acquired was approximately $5.7 million. The Company recorded an intangible asset related to the acquired company’s customer relationships of

18




$2.9 million and the remaining $2.8 million has been recognized as goodwill. The estimated useful life of the $2.9 million intangible asset is 15 years.

On July 26, 2006, the Company completed the purchase of the assets of Cass County Telephone Company Limited Partnership and LEC Long Distance, Inc., or Cass County, for approximately $33.0 million (or $28.8 million net of liabilities assumed), subject to adjustment. The Company incurred acquisition costs of $0.2 million. Cass County served approximately 8,600 access line equivalents, as of the date of acquisition, in Missouri and Kansas. The acquisition of the assets of Cass County has been accounted for using the purchase method of accounting for business combinations and, accordingly, the acquired assets and liabilities have been recorded at their estimated fair values as of the date of acquisition, and its results of operations have been included in the Company’s consolidated financial statements from the date of acquisition. Based upon the Company’s preliminary purchase price allocation, subject to final determination of the working capital adjustment and final settlement of an escrow (for potential contingent liabilities), the excess of the purchase price and acquisition costs over the fair value of the net identifiable assets acquired was approximately $14.1 million. The Company recorded an intangible asset related to the acquired company’s customer relationships of $5.3 million and the remaining $8.8 million has been recognized as goodwill. The estimated useful life of the $5.3 million intangible asset is 15 years.

(12)   Litigation

On June 6, 2005, a purported class action complaint was filed in the General Court of Justice, Superior Court Division, of the State of North Carolina by Robert Lowinger on behalf of himself and all other similarly situated persons against the Company, the Company’s Chairman and Chief Executive Officer, certain of the Company’s current and former directors and certain of the Company’s stockholders. The complaint alleges violations of Sections 11 and 12(a)(2) and liability under Section 15 of the Securities Act, and alleges that the Company’s registration statement on Form S-1 (which was declared effective by the SEC on February 3, 2005) and the related prospectus dated February 3, 2005, each relating to the Company’s initial public offering of common stock, contained certain material misstatements and omitted certain material information necessary to be included relating to the Company’s broadband products and access line trends. The plaintiff, who has been a plaintiff in several prior securities cases, seeks rescission rights and unspecified damages on behalf of a purported class of purchasers of the common stock “issued pursuant and/or traceable to the Company’s IPO during the period from February 3, 2005 through March 21, 2005”. The Company removed the action to Federal Court. The plaintiff filed a motion to remand the action to the North Carolina State Court, which was denied by the Federal Magistrate. The plaintiff has objected to and appealed the Magistrate’s decision to the District Court Judge. The Company has contested the appeal and filed a Motion to Dismiss the action. The Magistrate, on February 9, 2006, issued a Memorandum and a Recommendation to the District Court Judge that the Motion to Dismiss be granted and that the complaint be dismissed with prejudice. The plaintiff has filed a Notice of Objection to the Magistrate’s Recommendation. Both the appeal of denial of the Motion to Remand and the Motion to Dismiss are pending before the District Court Judge. The Company believes that this action is without merit and intends to continue to defend the litigation vigorously.

From time to time, the Company is involved in litigation and regulatory proceedings arising out of its operations. Management believes that the Company is not currently a party to any legal proceedings, the adverse outcome of which, individually or in the aggregate, would have a material adverse effect on the Company’s financial position or results of operations.

19




Item 2.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis provides information that the Company’s management believes is relevant to an assessment and understanding of the consolidated results of operations and financial condition of FairPoint Communications, Inc. and its subsidiaries. The discussion should be read in conjunction with FairPoint’s Consolidated Financial Statements for the year ended December 31, 2005 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Overview

We are a leading provider of communications services in rural communities, offering an array of services, including local and long distance voice, data, Internet and broadband product offerings. We are one of the largest telephone companies in the United States focused on serving rural communities and we are the 14th largest local telephone company, in each case based on number of access lines. We operate in 18 states with 308,858 access line equivalents (including voice access lines and high speed data lines, or HSD, which include digital subscriber lines, or DSL, wireless broadband and cable modems) in service as of September 30, 2006.

We were incorporated in February 1991 for the purpose of acquiring and operating local exchange carriers in rural markets. Since 1993, we have acquired 34 such businesses, 30 of which we continue to own and operate. Many of our telephone companies have served their respective communities for over 75 years. The majority of the rural communities we serve have fewer than 2,500 access lines. All of our telephone companies qualify as rural local exchange carriers under the Telecommunications Act of 1996, or the Telecommunications Act.

Rural local exchange carriers generally are characterized by stable operating results and strong cash flow margins and operate in supportive regulatory environments. In particular, existing state and federal regulations permit us to charge rates that enable us to recover our operating costs, plus a reasonable rate of return on our invested capital (as determined by relevant regulatory authorities). Competition is typically limited because rural local exchange carriers primarily serve sparsely populated rural communities with predominantly residential customers, and the cost of operations and capital investment requirements for new entrants is high. As a result, in our markets, while we have experienced some voice competition from cable providers, it has been limited and we have experienced limited wireline competition. We also are subject to competition from wireless and various other technologies which may increase in the future. If competition were to increase, the originating and terminating access revenues we receive may be reduced as a result of wireless, voice over internet protocol, or VOIP, or other new technology utilization. We periodically negotiate interconnection agreements with other telecommunications providers which could ultimately result in increased competition in those markets.

Access lines are an important element of our business. Historically, rural telephone companies have experienced consistent growth in access lines because of positive demographic trends, insulated rural local economies and little competition. Recently, however, many rural telephone companies have experienced a loss of access lines due to challenging economic conditions, increased competition and the introduction of DSL services (resulting in customers canceling second lines in favor of DSL). We have not been immune to these conditions. We have been able to mitigate our access line loss somewhat through bundling services, retention programs, continued community involvement and a variety of other focused programs.

During the third quarter of 2006, we completed the conversion of all access lines previously billed on the ICMS platform to the MACC Customer Master platform (approximately 65% of total access line equivalents). The conversion of the remaining companies is expected to be completed by early 2007.

Our board of directors has adopted a dividend policy which reflects our judgment that our stockholders would be better served if we distributed a substantial portion of the cash generated by our

20




business in excess of operating needs, interest and principal payments on our indebtedness, dividends on future senior classes of our capital stock, if any, capital expenditures, taxes and future reserves, if any, as regular quarterly dividend payments to the holders of our common stock, rather than retained and used for other purposes.

We are subject to regulation primarily by federal and state governmental agencies. At the federal level, the FCC has jurisdiction over interstate and international communications services. State telecommunications regulators exercise jurisdiction over intrastate communications services.

We face risks that could materially adversely affect our business, consolidated financial condition, results of operations, liquidity and/or the market price of our common stock. For a discussion of certain of the risks facing us, see Exhibit 99.1 to our Quarterly Report on Form 10-Q for the period ended March 31, 2006.

Revenues

We derive our revenues from:

·       Local calling services.   We receive revenues from providing local exchange telephone services, including monthly recurring charges for basic service, usage charges for local calls and service charges for special calling features.

·       Universal Service Fund high cost loop support.   We receive payments from the Universal Service Fund to support the high cost of our operations in rural markets. This revenue stream fluctuates based upon our average cost per loop compared to the national average cost per loop. For example, if the national average cost per loop increases and our operating costs (and average cost per loop) remain constant or decrease, the payments we receive from the Universal Service Fund would decline. Conversely, if the national average cost per loop decreases and our operating costs (and average cost per loop) remain constant or increase, the payments we receive from the Universal Service Fund would increase. The national average cost per loop in relation to our average cost per loop has increased, and we believe that the national average cost per loop will likely continue to increase in relation to our average cost per loop. As a result, the payments we receive from the Universal Service Fund have declined and will likely continue to decline.

·       Interstate access revenue.   These revenues are primarily based on a regulated return on rate base and recovery of allowable expenses associated with the origination and termination of interstate long distance telephone calls both to and from our customers. Interstate access charges to long distance carriers and other customers are based on access rates filed with the Federal Communications Commission. These revenues also include Universal Service Fund payments for local switching support, long term support and interstate common line support.

·       Intrastate access revenue.   These revenues consist primarily of charges paid by long distance companies and other customers for access to our networks in connection with the origination and termination of intrastate long distance telephone calls both to and from our customers. Intrastate access charges to long distance carriers and other customers are based on access rates filed with the state regulatory agencies.

·       Long distance services.   We receive revenues from long distance services we provide to our residential and business customers. In addition, Carrier Services provides communications providers not affiliated with us with wholesale long distance services.

·       Data and Internet services.   We receive revenues from monthly recurring charges for services, including high speed data, special access, private lines, Internet and other services.

21




·       Other services.   We receive revenues from other services, including billing and collection, directory services and sale and maintenance of customer premise equipment.

The following summarizes our revenues and percentage of revenues from continuing operations from these sources (in thousands):

 

 

Revenues

 

% of Revenues

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

Revenue Source

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Local calling services

 

$

16,984

 

$

16,586

 

$

49,875

 

$

48,185

 

 

24

%

 

 

25

%

 

 

25

%

 

 

25

%

 

Universal service fund-high cost loop

 

5,116

 

5,045

 

14,666

 

14,548

 

 

7

%

 

 

8

%

 

 

7

%

 

 

8

%

 

Interstate access
revenues

 

19,399

 

17,697

 

53,624

 

54,660

 

 

28

%

 

 

27

%

 

 

27

%

 

 

28

%

 

Intrastate access
revenues

 

10,150

 

10,227

 

28,015

 

29,844

 

 

14

%

 

 

15

%

 

 

14

%

 

 

15

%

 

Long distance services

 

6,525

 

5,694

 

17,553

 

15,174

 

 

9

%

 

 

9

%

 

 

9

%

 

 

8

%

 

Data and Internet
services

 

7,120

 

6,230

 

20,693

 

17,759

 

 

10

%

 

 

9

%

 

 

10

%

 

 

9

%

 

Other services

 

5,406

 

4,559

 

15,261

 

12,739

 

 

8

%

 

 

7

%

 

 

8

%

 

 

7

%

 

Total

 

$

70,700

 

$

66,038

 

$

199,687

 

$

192,909

 

 

100

%

 

 

100

%

 

 

100

%

 

 

100

%

 

 

Operating Expenses

Our operating expenses are categorized as operating expenses and depreciation and amortization.

·       Operating expenses include cash expenses incurred in connection with the operation of our central offices and outside plant facilities and related operations. In addition to the operational costs of owning and operating our own facilities, we also purchase long distance services from the regional bell operating companies, large independent telephone companies and third party long distance providers. In addition, our operating expenses include expenses relating to sales and marketing, customer service and administration and corporate and personnel administration. Also included in operating expenses are non-cash expenses related to stock based compensation. Stock based compensation consists of compensation charges incurred in connection with the employee stock options, stock units and non-vested stock granted to our executive officers and directors.

·       Depreciation and amortization includes depreciation of our communications network and equipment.

Acquisitions

We intend to continue to pursue selective acquisitions:

·       On September 13, 2006, the Company and certain subsidiaries entered into an Agreement and Plan of Merger with The Germantown Independent Telephone Company, or GITC. On October 16, 2006, we announced that the shareholders of GITC approved the merger. The merger consideration is $10.2 million. This transaction is expected to close in the fourth quarter of 2006. GITC is a single exchange rural incumbent local exchange carrier located in the Village of Germantown, Ohio, serving approximately 4,400 access line equivalents. We refer to this merger herein as the GITC merger.

22




·       On August 17, 2006, we completed the purchase of Unite for approximately $11.5 million (or $8.9 million net of cash acquired and debt assumed), subject to adjustment. Unite owns ExOp of Missouri, Inc., which is a facilities-based voice, data and video service provider located outside of Kansas City, Missouri. Unite serves approximately 4,200 access lines in Kearney and Platte City, Missouri, approximately 50 miles north of the Cass County service territory.

·       On July 26, 2006, we completed the purchase of the assets of Cass County, for approximately $33.0 million (or $28.8 million net of liabilities assumed), subject to adjustment. Cass County served approximately 8,600 access line equivalents, as of the date of acquisition, in Missouri and Kansas.

·       On May 2, 2005, we completed the acquisition of Berkshire Telephone Corporation, or Berkshire, for a purchase price of approximately $20.3 million (or $16.4 million net of cash acquired). Berkshire is an independent local exchange carrier that provides voice communication, cable and internet services to over 7,200 access line equivalents, as of the date of acquisition, serving five communities in New York State. Berkshire’s communities of service are adjacent to those of Taconic Telephone Corp., one of the Company’s subsidiaries.

·       On September 1, 2005, we completed the acquisition of Bentleyville Communications Corporation, or Bentleyville, for a purchase price of approximately $11.0 million (or $9.3 million net of cash acquired). Bentleyville, which had approximately 3,600 access line equivalents as of the date of acquisition, provides telecommunications, cable and internet services to rural areas of Southwestern Pennsylvania which are adjacent to our existing operations in Pennsylvania.

In the normal course of business, we evaluate selective acquisitions and may enter into non-binding letters of intent with respect to such acquisitions, subject to customary conditions. Management currently intends to fund future acquisitions through the use of the revolving facility of our credit facility or additional debt financing or the issuance of additional shares of our common stock. However, our substantial amount of indebtedness and our dividend policy could restrict our ability to obtain such financing on acceptable terms or at all.

Results of Operations

The following tables set forth the percentages of revenues represented by selected items reflected in our consolidated statements of operations. The comparisons of financial results are not necessarily indicative of future results.

23




Three Months Ended September 30, 2006 Compared with Three Months Ended September 30, 2005

 

 

Three months ended
September 30,

 

Three months ended
September 30,

 

 

 

2006

 

% of revenue

 

2005

 

% of revenue

 

 

 

(in thousands)

 

Revenues

 

$

70,700

 

 

100.0

%

 

$

66,038

 

 

100.0

%

 

Operating expenses

 

40,362

 

 

57.1

%

 

38,470

 

 

58.3

%

 

Depreciation and amortization

 

12,839

 

 

18.1

%

 

12,947

 

 

19.6

%

 

Total operating expenses

 

53,201

 

 

75.2

%

 

51,417

 

 

77.9

%

 

Income from operations

 

17,499

 

 

24.8

%

 

14,621

 

 

22.1

%

 

Net gain (loss) on sale of investments and other
assets

 

64

 

 

0.1

%

 

(15

)

 

(0.0

)%

 

Interest and dividend income

 

211

 

 

0.3

%

 

398

 

 

0.6

%

 

Interest expense

 

(9,969

)

 

(14.1

)%

 

(10,026

)

 

(15.2

)%

 

Equity in net earnings of investees

 

1,841

 

 

2.6

%

 

2,716

 

 

4.1

%

 

Total other income (expense)

 

(7,853

)

 

(11.1

)%

 

(6,927

)

 

(10.5

)%

 

Income before income taxes

 

9,646

 

 

13.7

%

 

7,694

 

 

11.6

%

 

Income tax expense

 

(3,668

)

 

(5.2

)%

 

(3,504

)

 

(5.3

)%

 

Minority interest in income of subsidiaries

 

(1

)

 

(0.0

)%

 

(1

)

 

(0.0

)%

 

Net income

 

$

5,977

 

 

8.5

%

 

$

4,189

 

 

6.3

%

 

 

Revenues

Revenues.   Revenues increased $4.7 million to $70.7 million in 2006 compared to $66.0 million in 2005. Excluding the impact of acquired operations, revenues increased $1.6 million compared to the third quarter of 2005. We derived our revenues from the following sources:

Local calling services.   Local calling service revenues increased $0.4 million to $17.0 million in 2006 compared to $16.6 million in 2005. Excluding the impact of acquired operations, local calling service revenues decreased $0.5 million compared to the third quarter of 2005. Voice access lines, including lines acquired, increased 1.2% from the third quarter of 2005. Voice access lines, excluding acquired lines, decreased 3.5% from the third quarter of 2005.

Universal Service Fund high cost loop.   Universal Service Fund high cost loop receipts increased $0.1 million to $5.1 million in the third quarter of 2006 compared to the third quarter of 2005. Excluding the impact of acquired operations, universal service fund revenues decreased $0.2 million compared to the third quarter of 2005.

Interstate access revenues.   Interstate access revenues were $19.4 million for the three months ended September 30, 2006 compared to $17.7 million for the three months ended September 30, 2005. Excluding the impact of acquired companies, interstate access revenues increased $0.8 million compared to 2005. This increase is primarily the result of revenue requirement factors adjusted based on recent cost study filings. These occur periodically in the normal course of business.

Intrastate access revenues.   Intrastate access revenues decreased $0.1 million to $10.2 million for the three months ended September 30, 2006. Excluding the impact of acquired companies, intrastate access revenues decreased $0.4 million compared to 2005. Intrastate access revenue declined primarily due to a decrease in access rates and a decrease in minutes of use compared to the third quarter of 2005. Intrastate access revenues are expected to continue to decline.

24




Long distance services.   Long distance services revenues increased $0.8 million from $5.7 million in 2005 to $6.5 million in 2006. This is attributable to the increase in subscribers and minutes related to bundles and packages sold to our existing customers. Interstate long distance penetration as of September 30, 2006 was 45.6% of voice access lines as compared to 42.3% as of September 30, 2005.

Data and Internet services.   Data and Internet services revenues increased $0.9 million to $7.1 million in 2006 compared to 2005. Excluding the impact of acquired companies, data and Internet revenues increased $0.7 million compared to 2005. This increase is due primarily to increases in high speed data customers as we continue to market our broadband services. Our high speed data subscribers increased from 43,103 as of September 30, 2005 to 57,095 as of September 30, 2006 and represents a 22.7% penetration of voice access lines.

Other services.   Other services revenues increased from $4.6 million in 2005 to $5.4 million in 2006. Excluding the impact of acquired companies, other services revenues increased $0.5 million compared to 2005. This increase is principally driven by an increase in directory revenues in 2006.

Operating Expenses

Operating expenses, excluding depreciation and amortization.   Operating expenses increased $1.9 million to $40.4 million in 2006 from $38.5 million in 2005. Approximately $1.5 million of this increase is related to operating expenses of the companies acquired in the last twelve months. This increase also results from an increase in expenses related to HSD and long distance services of $1.0 million and an increase in employee compensation expenses of $0.6 million, partially offset by a decrease in bad debt expenses of $1.0 million and a decrease in consulting expenses of $0.5 million. Included in operating expenses are non-cash stock based compensation expenses associated with the award of restricted stock and restricted units. For the three months ended September 30, 2006 and 2005, stock based compensation expenses totaled $0.8 million and $0.6 million, respectively.

Depreciation and amortization.   Depreciation and amortization expense decreased $0.1 million to $12.8 million in 2006.

Income from operations.   Income from operations increased $2.9 million to $17.5 million in 2006. This increase was driven principally by income from operations of companies acquired in the last twelve months. In general, income from operations has been declining due to the increased percentage of lower margin unregulated revenues in our total business mix due to HSD and long distance revenue growth, which offset declining higher margin regulated revenues. In addition to the increase in unregulated products, we experienced declines in local and intrastate revenues which have significantly higher margins and we have also experienced an increase in operating expenses.

Other income (expense).   Total other income (expense) increased $0.9 million to $(7.9) million in 2006. The primary driver of this increase in expenses was a reduction in equity in net earnings of investees of $0.9 million. In addition, gains on sale of investments increased $0.1 million, interest and dividend income decreased $0.2 million and interest expense decreased $0.1 million to $9.9 million in 2006.

Income tax (expense) benefit.   Income tax expense of $3.7 million was recorded for the three months ended September 30, 2006, resulting in an effective rate of 38.0% as compared to 45.5% as of September 30, 2005. Our accounting policy is to report income tax expense for interim reporting periods using an estimated annual effective income tax rate. However, the effects of significant or unusual items are not considered in the estimated annual effective tax rate. The tax effect of such events is recognized in the interim period in which the event occurs.

Net income.   Net income was $6.0 million for the three months ended September 30, 2006 as compared to net income of $4.2 million for the three months ended September 30, 2005. The differences between 2006 and 2005 are a result of the factors discussed above.

25




Nine Months Ended September 30, 2006 Compared with Nine Months Ended September 30, 2005

 

 

Nine months ended September 30,

 

Nine months ended September 30,

 

 

 

      2006      

 

    % of revenue     

 

      2005      

 

    % of revenue     

 

 

 

(in thousands)

 

Revenues

 

 

$

199,687

 

 

 

100.0

%

 

$

192,909

 

 

100.0

%

 

Operating expenses

 

 

112,242

 

 

 

56.2

%

 

106,234

 

 

55.1

%

 

Depreciation and amortization

 

 

39,826

 

 

 

20.0

%

 

39,063

 

 

20.2

%

 

Total operating expenses

 

 

152,068

 

 

 

76.2

%

 

145,297

 

 

75.3

%

 

Income from operations

 

 

47,619

 

 

 

23.8

%

 

47,612

 

 

24.7

%

 

Net gain (loss) on sale of investments and other assets

 

 

14,289

 

 

 

7.2

%

 

(199

)

 

(0.1

)%

 

Interest and dividend income

 

 

3,138

 

 

 

1.6

%

 

1,670

 

 

0.9

%

 

Interest expense

 

 

(29,514

)

 

 

(14.8

)%

 

(36,584

)

 

(19.0

)%

 

Equity in net earnings of investees

 

 

8,206

 

 

 

4.1

%

 

8,168

 

 

4.2

%

 

Other non-operating, net

 

 

 

 

 

 

 

(87,746

)

 

(45.5

)%

 

Total other income (expense)

 

 

(3,881

)

 

 

(1.9

)%

 

(114,691

)

 

(59.5

)%

 

Income (loss) before income taxes

 

 

43,738

 

 

 

21.9

%

 

(67,079

)

 

(34.8

)%

 

Income tax benefit (expense)

 

 

(16,965

)

 

 

(8.5

)%

 

87,915

 

 

45.6

%

 

Minority interest in income of subsidiaries

 

 

(2

)

 

 

(0.0

)%

 

(2

)

 

(0.0

)%

 

Net income

 

 

$

26,771

 

 

 

13.4

%

 

$

20,834

 

 

10.8

%

 

 

Revenues

Revenues.   Revenues increased $6.8 million to $199.7 million in 2006 compared to $192.9 million in 2005. Excluding the impact of acquired operations, revenues increased $0.2 million compared to the prior year. We derived our revenues from the following sources:

Local calling services.   Local calling service revenues increased $1.7 million to $49.9 million in 2006 compared to $48.2 million in 2005. Excluding the impact of acquired operations, local calling service revenues increased $0.1 million compared to 2005. Voice access lines, including lines acquired, increased 1.2% from September 30, 2005. Voice access lines, excluding acquired lines, decreased 3.5% from September 30, 2005.

Universal Service Fund high cost loop.   Universal Service Fund high cost loop receipts increased $0.1 million in the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. Excluding the impact of acquired operations, universal service fund revenues decreased $0.1 million compared to the prior year.

Interstate access revenues.   Interstate access revenues were $53.6 million for the nine months ended September 30, 2006 compared to $54.7 million for the nine months ended September 30, 2005. Excluding the impact of acquired companies, interstate access revenues decreased $2.7 million compared to 2005. The primary drivers of this decrease were decreases in revenue settlements and adjustments related to prior years. In the second quarter of 2005, these revenue settlements and adjustments increased revenue by $1.9 million while in the second quarter of 2006, the settlements and adjustments decreased revenue by approximately $1.0 million. Therefore, the two adjustments combined resulted in a decrease in interstate revenues of $2.9 million for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005.

Intrastate access revenues.   Intrastate access revenues decreased $1.8 million to $28.0 million in 2006 compared to 2005. Excluding the impact of acquired companies, intrastate access revenues decreased $2.9 million compared to 2005. Intrastate access revenue declined primarily due to a decrease in access

26




rates and a decrease in minutes of use compared to 2005. The rate decrease is primarily due to intrastate rate reductions implemented in Maine in the second quarter of 2005. Intrastate access revenues are expected to continue to decline.

Long distance services.   Long distance services revenues increased $2.4 million from $15.2 million in 2005 to $17.6 million in 2006. Excluding the impact of acquired operations, long distance services revenues increased $2.1 million compared to the nine months ended September 30, 2005. This is attributable to the increase in subscribers and minutes related to bundles and packages sold to our existing customers. Interstate long distance penetration as of September 30, 2006 was 45.6% of voice access lines as compared to 42.3% as of September 30, 2005.

Data and Internet services.   Data and Internet services revenues increased $2.9 million to $20.7 million in 2006 compared to 2005. Excluding the impact of acquired operations, data and Internet services revenues increased $2.3 million compared to the nine months ended September 30, 2005. This increase is due primarily to increases in high speed data customers as we continue to market our broadband services. Our HSD subscribers increased from 43,103 as of September 30, 2005 to 57,095 as of September 30, 2006 and represents a 22.7% penetration of voice access lines.

Other services.   Other services revenues increased from $12.7 million in 2005 to $15.3 million in 2006. Excluding the impact of acquired companies, other services revenues increased $1.4 million compared to 2005. This increase is principally driven by an increase in directory revenues in 2006.

Operating Expenses

Operating expenses, excluding depreciation and amortization.   Operating expenses increased $6.0 million to $112.2 million in 2006 from $106.2 million in 2005. Approximately $3.9 million of this increase is related to operating expenses of the companies acquired in the last twelve months. This increase also results from an increase in billing expenses of $1.3 million, an increase in expenses related to HSD and long distance services of $1.3 million, an increase in employee compensation expenses of $1.1 million, an increase in audit and tax related expenses of $0.7 million and an increase in operating taxes of $0.6 million. These increases were partially offset by a decrease in consulting expenses of $2.2 million due to expenses incurred in 2005 related to our preparation for compliance under Section 404 of the Sarbanes-Oxley Act and a decrease in bad debt expenses of $1.3 million. Included in operating expenses are non-cash stock based compensation expenses associated with the award of restricted stock and restricted units. For the nine months ended September 30, 2006 and 2005, stock based compensation expenses totaled $2.0 million and $1.7 million, respectively.