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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 June 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

 

(I.R.S. Employer

Incorporation or Organization)

 

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 August 1, 2006, there were 35,039,235 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 June 30, 2006 and December 31, 2005

 

 

4

 

 

 

 

Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005

 

 

5

 

 

 

 

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

 

 

6

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the six months ended June 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

 

 

19

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

32

 

 

Item 4.

 

Controls and Procedures

 

 

32

 

 

PART II. OTHER INFORMATION

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

33

 

 

Item 1A.

 

Risk Factors

 

 

33

 

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

 

33

 

 

Item 3.

 

Defaults Upon Senior Securities

 

 

34

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

34

 

 

Item 5.

 

Other Information

 

 

34

 

 

Item 6.

 

Exhibits

 

 

34

 

 

 

 

Signatures

 

 

35

 

 

 

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

 

 

June 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

(unaudited)

 

 

 

 

 

(Dollars in thousands)

 

Assets

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash

 

$

41,228

 

 

$

5,083

 

 

Accounts receivable, net

 

28,026

 

 

34,985

 

 

Other

 

13,616

 

 

9,200

 

 

Deferred income tax, net

 

22,504

 

 

29,190

 

 

Assets of discontinued operations

 

 

 

90

 

 

Total current assets

 

105,374

 

 

78,548

 

 

Property, plant, and equipment, net

 

229,631

 

 

242,617

 

 

Investments

 

11,708

 

 

39,808

 

 

Goodwill

 

482,315

 

 

481,343

 

 

Deferred income tax, net

 

39,233

 

 

47,160

 

 

Deferred charges and other assets

 

22,908

 

 

18,663

 

 

Total assets

 

$

891,169

 

 

$

908,139

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

13,670

 

 

$

12,030

 

 

Dividends payable

 

13,835

 

 

13,789

 

 

Current portion of long-term debt

 

696

 

 

677

 

 

Demand notes payable

 

333

 

 

338

 

 

Accrued interest payable

 

207

 

 

288

 

 

Other accrued liabilities

 

15,037

 

 

20,808

 

 

Liabilities of discontinued operations

 

1,447

 

 

2,495

 

 

Total current liabilities

 

45,225

 

 

50,425

 

 

Long-term liabilities:

 

 

 

 

 

 

 

Long-term debt, net of current portion

 

592,620

 

 

606,748

 

 

Deferred credits and other long-term liabilities

 

6,853

 

 

4,108

 

 

Total long-term liabilities

 

599,473

 

 

610,856

 

 

Minority interest

 

9

 

 

10

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

Common stock

 

350

 

 

350

 

 

Additional paid-in capital

 

556,809

 

 

590,131

 

 

Unearned compensation

 

 

 

(6,475

)

 

Accumulated deficit

 

(321,841

)

 

(342,635

)

 

Accumulated other comprehensive income, net

 

11,144

 

 

5,477

 

 

Total stockholders’ equity

 

246,462

 

 

246,848

 

 

Total liabilities and stockholders’ equity

 

$

891,169

 

 

$

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

 

Six months ended

 

 

 

June 30,

 

June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(Dollars in thousands)

 

Revenues

 

$

64,196

 

$

65,206

 

$

128,987

 

$

126,871

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Operating expenses, excluding depreciation and amortization

 

36,275

 

35,321

 

71,880

 

67,764

 

Depreciation and amortization

 

13,352

 

13,106

 

26,987

 

26,116

 

Total operating expenses

 

49,627

 

48,427

 

98,867

 

93,880

 

Income from operations

 

14,569

 

16,779

 

30,120

 

32,991

 

Other income (expense):

 

 

 

 

 

 

 

 

 

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

 

14,277

 

(6

)

14,225

 

(184

)

Interest and dividend income

 

2,587

 

720

 

2,927

 

1,272

 

Interest expense

 

(9,792

)

(9,588

)

(19,545

)

(26,558

)

Equity in net earnings of investees

 

3,079

 

2,796

 

6,365

 

5,452

 

Other non-operating, net

 

 

(1,582

)

 

(87,746

)

Total other income (expense)

 

10,151

 

(7,660

)

3,972

 

(107,764

)

Income (loss) before income taxes

 

24,720

 

9,119

 

34,092

 

(74,773

)

Income tax (expense) benefit

 

(9,645

)

(3,515

)

(13,297

)

91,419

 

Minority interest

 

(1

)

(1

)

(1

)

(1

)

Net income

 

$

15,074

 

$

5,603

 

$

20,794

 

$

16,645

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

34,649

 

34,549

 

34,601

 

29,260

 

Diluted

 

34,683

 

34,566

 

34,665

 

29,315

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.44

 

$

0.16

 

$

0.60

 

$

0.57

 

Diluted

 

$

0.43

 

$

0.16

 

$

0.60

 

$

0.57

 

 

See accompanying notes to condensed consolidated financial statements

5




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

 

 

Three months ended

 

Six months ended

 

 

 

June 30,

 

June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(Dollars in thousands)

 

Net income

 

$

15,074

 

$

5,603

 

$

20,794

 

$

16,645

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Cash flow hedges:

 

 

 

 

 

 

 

 

 

Change in net unrealized gain, net of tax expense of $1.4 million and $3.3 million as of the three months ended June 30, 2006 and 2005, respectively, and net of tax expense of $3.4 million and $1.0 million for the six months ended June 30, 2006 and 2005, respectively

 

2,293

 

(5,479

)

5,667

 

(1,766

)

Comprehensive income

 

$

17,367

 

$

124

 

$

26,461

 

$

14,879

 

 

See accompanying notes to condensed consolidated financial statements.

6




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

 

 

Six months ended

 

 

 

June 30,

 

 

 

2006

 

2005

 

 

 

(Dollars in thousands)

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

20,794

 

$

16,645

 

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

 

11,873

 

(92,706

)

Amortization of debt issue costs

 

825

 

1,095

 

Depreciation and amortization

 

26,987

 

26,116

 

Loss on early retirement of debt

 

 

77,847

 

Minority interest in income of subsidiaries

 

1

 

1

 

Income from equity method investments

 

(6,365

)

(5,452

)

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

 

(14,225

)

184

 

Other non cash items

 

668

 

1,046

 

Changes in assets and liabilities arising from operations:

 

 

 

 

 

Accounts receivable and other current assets

 

6,472

 

(1,795

)

Accounts payable and accrued expenses

 

118

 

(17,717

)

Income taxes

 

234

 

(342

)

Other assets/liabilities

 

(130

)

110

 

Total adjustments

 

26,458

 

648

 

Net cash provided by operating activities of continuing operations

 

47,252

 

17,293

 

Cash flows from investing activities of continuing operations:

 

 

 

 

 

Acquisitions of telephone properties, net of cash acquired

 

 

(16,449

)

Net capital additions

 

(17,536

)

(9,652

)

Distributions from investments

 

5,740

 

4,791

 

Net proceeds from sales of investments and other assets

 

43,358

 

174

 

Other, net

 

(111

)

(281

)

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

 

31,451

 

(21,417

)

Cash flows from financing activities of continuing operations:

 

 

 

 

 

Net proceeds from issuance of common stock

 

 

431,921

 

Debt issue and offering costs

 

 

(8,468

)

Proceeds from issuance of long-term debt

 

26,450

 

638,484

 

Repayments of long-term debt

 

(40,515

)

(847,842

)

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

 

(27,559

)

(7,788

)

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

 

(41,600

)

7,731

 

Cash flows of discontinued operations:

 

 

 

 

 

Operating cash flows, net used in

 

(958

)

(510

)

Net increase in cash

 

36,145

 

3,097

 

Cash, beginning of period

 

5,083

 

3,595

 

Cash, end of period

 

$

41,228

 

$

6,692

 

 

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 June 30, 2006 and for the three and six month periods ended June 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 June 21, 2006, the Company declared a dividend totaling $13.8 million, or $0.39781 per share of common stock, which was paid on July 21, 2006 to holders of record as of July 6, 2006. In 2006, the Company has paid dividends totaling $27.6 million, or $0.79562 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 considered in the estimated annual effective tax rate. The tax effect of such events is recognized in the

8




interim period in which the event occurs.For the three months ended June 30, 2006, the Company recorded income tax expense of $9.6 million, resulting in an effective rate of 39.0% compared to 38.5% for the three months ended June 30, 2005.

For the six months ended June 30, 2006, the Company recorded income tax expense of $13.3 million, resulting in an effective rate of 39.0%. The Company’s effective annual tax rate is estimated to be 38.6% for 2006. For the six months ended June 30, 2005, the Company recorded an income tax benefit of $91.4 million. The income tax benefit and effective tax rate for the six months ended June 30, 2005 were primarily impacted by unusual items occurring in 2005. Income tax benefits of $23.8 million were recognized due to the taxable loss for the six months ended June 30, 2005 resulting from losses on the extinguishment of debt. In addition, for the six months ended June 30, 2005, the Company recognized income tax benefits of $66.0 million from the reversal of the deferred tax valuation allowance that resulted from the Company’s expectation of generating future taxable income following the recapitalization. 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. 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 June 30, 2006. At June 30, 2006, the Company had $6.3 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 2.4 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
June 30,

 

Six months
ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Amounts charged against income, before income tax benefit

 

$

670

 

$

685

 

$

1,284

 

$

1,092

 

Amount of related income tax benefit recognized in income

 

252

 

258

 

483

 

411

 

Total net income impact

 

$

418

 

$

427

 

$

801

 

$

681

 

 

(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

9




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 stock price was made. As of June 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.

10




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

Options outstanding

 

Options exercisable

 

 

 

Number

 

 

 

 

 

Number

 

 

 

outstanding at

 

Remaining

 

Aggregate

 

exercisable at

 

Exercise

 

June 30,

 

contractual

 

Intrinsic

 

June 30,

 

price

 

2006

 

life (years)

 

Value

 

2006

 

 

 

 

 

 

 

(in thousands)

 

 

 

$9.02

 

 

756,332

 

 

 

2.1

 

 

 

4,069

 

 

 

 

 

14.46

 

 

29,183

 

 

 

3.0

 

 

 

 

 

 

 

 

36.94

 

 

47,373

 

 

 

5.5

 

 

 

 

 

 

 

 

 

 

 

832,888

 

 

 

 

 

 

 

4,069

 

 

 

 

 

 

The weighted average remaining contractual life for the options outstanding at June 30, 2006 is 2.3 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 $14.40 on June 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 June 30, 2006 and December 31, 2005, there were 240,638 options outstanding under the 2000 Plan with a weighted average exercise price of $36.94 and remaining contractual life of 6.4 years. As of June 30, 2006, 218,937 options with a remaining contractual life of 6.2 years were exercisable with a

11




weighted average exercise price of $36.94. Based upon the fair market value of the stock as of June 30, 2006 of $14.40, these options do not have any intrinsic value.

As of June 30, 2006, there were 26,442 stock units outstanding with a weighted average grant date fair value per share of $32.51. None of these awards were vested as of June 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. At June 30, 2006, up to 469,500 additional shares of common stock may be issued in the future pursuant to awards authorized under the 2005 Plan.

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. 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 June 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

 

Non-vested stock

 

 

 

outstanding

 

per share

 

Non-vested at January 1, 2006

 

 

470,029

 

 

 

$

18.13

 

 

Granted

 

 

50,000

 

 

 

14.02

 

 

Vested

 

 

(119,219

)

 

 

18.50

 

 

Forfeited

 

 

(13,423

)

 

 

18.50

 

 

Non-vested at June 30, 2006

 

 

387,387

 

 

 

17.47

 

 

 

(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 June 30, 2006 and December 31, 2005 were $1.4 million and $2.4 million, respectively. The remaining restructuring accrual at June 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.

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

 

 

13




As a result of these swap agreements, as of June 30, 2006, approximately 92% 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 six months ended June 30, 2006. At June 30, 2006, the fair market value of these swaps was approximately $17.9 million and has been recorded, net of tax of $6.7 million, as an increase in comprehensive income. Of the $17.9 million, $7.1 million has been included in other current assets and $10.8 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):

 

 

March 31,
2006

 

December 31,
2005

 

Current assets

 

 

$

11,432

 

 

 

$

9,812

 

 

Property, plant and equipment, net

 

 

37,556

 

 

 

37,516

 

 

Total assets

 

 

$

48,988

 

 

 

$

47,328

 

 

Total liabilities

 

 

$

679

 

 

 

$

432

 

 

Partners’ capital

 

 

48,309

 

 

 

46,896

 

 

 

 

 

$

48,988

 

 

 

$

47,328

 

 

 

 

 

Three months ended
March 31,

 

Six months ended
March 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenues

 

$

38,469

 

$

39,763

 

$

88,694

 

$

80,644

 

Operating income

 

30,195

 

33,846

 

70,878

 

67,357

 

Net income

 

30,413

 

33,955

 

71,389

 

67,729

 

 

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. 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 liquidation, 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.

14




On May 1, 2006, the Company completed the sale of its investment in Southern Illinois Cellular Corp. 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 June 30, 2006 and December 31, 2005 is shown below:

 

 

June 30,
2006

 

December 31,
2005

 

 

 

(In thousands)

 

Senior secured notes (credit facility), variable rate of 6.83% at June 30, 2006, due 2011 to 2012

 

$

588,500

 

 

$

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

 

2,766

 

 

3,100

 

 

Total outstanding long-term debt

 

593,316

 

 

607,425

 

 

Less current portion

 

(696

)

 

(677

)

 

Total long-term debt, net of current portion

 

$

592,620

 

 

$

606,748

 

 

 

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

Year ending June 30,

 

 

 

 

 

2007

 

$

696

 

2008

 

734

 

2009

 

452

 

2010

 

2,205

 

2011

 

166

 

Thereafter

 

589,063

 

 

 

$

593,316

 

 

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 June 30, 2006, the Company had borrowed the entire $588.5 million available under the term facility and had no borrowings 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.

15




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, 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 or 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).

16




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 June 30, 2006, a letter of credit had been issued for $1.3 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.

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 six months ended June 30, 2006 and June 30, 2005, diluted weighted average shares of common stock outstanding included 34,272 and 63,920 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
June 30,

 

Six months ended
June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Contingent stock options

 

833

 

833

 

833

 

833

 

Shares excluded as effect would be anti-dilutive:

 

 

 

 

 

 

 

 

 

Stock options

 

241

 

241

 

241

 

241

 

Restricted stock

 

464

 

466

 

441

 

466

 

Restricted stock units

 

37

 

33

 

38

 

33

 

Total

 

1,575

 

1,573

 

1,553

 

1,573

 

 

(10) Subsequent Event

On July 26, 2006, the Company announced that it had completed the purchase of the assets of Cass County Telephone Company Limited Partnership and LEC Long Distance, Inc. (collectively, Cass County) for the purchase price of approximately $33.0 million, subject to adjustment. Cass County provides

17




telecommunications and Internet services to rural areas of Missouri and Kansas. Cass County has approximately 8,600 access line equivalents currently in operation, consisting of approximately 6,800 residential lines, 1,000 business lines and 800 high speed data subscribers. The Company funded the Cass County acquisition from cash on hand and from borrowings under the revolving facility of our credit facility.

(11) 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.

18




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 17th largest local telephone company, in each case based on number of access lines. We operate in 17 states with 292,910 access line equivalents (including voice access lines and high speed data lines, which include digital subscriber lines, or DSL, wireless broadband and cable modems) in service as of June 30, 2006.

We were incorporated in February 1991 for the purpose of acquiring and operating incumbent telephone companies in rural markets. Since 1993, we have acquired 33 such businesses, 29 of which we continue to own and operate (including Cass County which was acquired in July 2006). 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, we have experienced limited wireline competition and limited voice competition from cable providers. 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.

We are continuing our billing conversion and have currently converted approximately 36% of the access lines billed on the ICMS platform to the MACC Customer Master platform. The conversion of the remaining companies currently on the ICMS platform is expected to be completed by September 9, 2006 with the remainder of the companies expected to be completed by early to mid 2007.

19




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 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.

20




·       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.

·       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 June 30,

 

Six months
ended June 30,

 

Three months
ended June 30,

 

Six months
ended June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

Revenue Source

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Local calling services

 

$

16,609

 

$

15,982

 

$

32,891

 

$

31,599

 

 

26

%

 

 

25

%

 

 

25

%

 

 

25

%

 

Universal service fund-high cost loop

 

4,731

 

4,707

 

9,550

 

9,503

 

 

7

%

 

 

7

%

 

 

7

%

 

 

7

%

 

Interstate access revenues

 

16,589

 

20,083

 

34,225

 

36,963

 

 

26

%

 

 

31

%

 

 

26

%

 

 

30

%

 

Intrastate access revenues

 

8,888

 

9,534

 

17,865

 

19,617

 

 

14

%

 

 

15

%

 

 

14

%

 

 

15

%

 

Long distance services

 

5,630

 

4,798

 

11,029

 

9,480

 

 

9

%

 

 

7

%

 

 

9

%

 

 

8

%

 

Data and Internet services

 

6,890

 

5,937

 

13,569

 

11,529

 

 

11

%

 

 

9

%

 

 

11

%

 

 

9

%

 

Other services

 

4,859

 

4,165

 

9,858

 

8,180

 

 

7

%

 

 

6

%

 

 

8

%

 

 

6

%

 

Total

 

$

64,196

 

$

65,206

 

$

128,987

 

$

126,871

 

 

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 July 26, 2006, we 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, subject to adjustment. Cass County served approximately 8,600 access line equivalents, as of the date of acquisition, in Missouri and Kansas.

·       On July 26, 2006, we announced an agreement to purchase Unite Communications Systems, Inc., or Unite, for approximately $10.8 million, 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.

21




·       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), subject to adjustment. 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.

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

 

 

Three months
ended June 30,

 

Three months
ended June 30,

 

 

 

2006

 

% of revenue

 

2005

 

% of revenue

 

 

 

(in thousands)

 

Revenues

 

$

64,196

 

 

100.0

%

 

$

65,206

 

 

100.0

%

 

Operating expenses

 

36,275

 

 

56.5

%

 

35,321

 

 

54.2

%

 

Depreciation and amortization

 

13,352

 

 

20.8

%

 

13,106

 

 

20.1

%

 

Total operating expenses

 

49,627

 

 

77.3

%

 

48,427

 

 

74.3

%

 

Income from operations

 

14,569

 

 

22.7

%

 

16,779

 

 

25.7

%

 

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

 

14,277

 

 

22.2

%

 

(6

)

 

(0.0

)%

 

Interest and dividend income

 

2,587

 

 

4.0

%

 

720

 

 

1.1

%

 

Interest expense

 

(9,792

)

 

(15.2

)%

 

(9,588

)

 

(14.7

)%

 

Equity in net earnings of investees

 

3,079

 

 

4.8

%

 

2,796

 

 

4.3

%

 

Other non-operating, net

 

 

 

 

 

(1,582

)

 

(2.4

)%

 

Total other income (expense)

 

10,151

 

 

15.8

%

 

(7,660

)

 

(11.7

)%

 

Income before income taxes

 

24,720

 

 

38.5

%

 

9,119

 

 

14.0

%

 

Income tax expense

 

(9,645

)

 

(15.0

)%

 

(3,515

)

 

(5.4

)%

 

Minority interest in income of subsidiaries

 

(1

)

 

(0.0

)%

 

(1

)

 

0.0

%

 

Net income

 

$

15,074

 

 

23.5

%

 

$

5,603

 

 

8.6

%

 

 

22




Revenues

Revenues.   Revenues decreased $1.0 million to $64.2 million in 2006 compared to $65.2 million in 2005. Excluding the impact of acquired operations, revenues decreased $2.4 million compared to the second quarter of 2005. We derived our revenues from the following sources:

Local calling services.   Local calling service revenues increased $0.6 million to $16.6 million in 2006 compared to $16.0 million in 2005. Excluding the impact of acquired operations, local calling service revenues increased $0.4 million compared to the second quarter of 2005. The primary driver of this increase is an increase in wireless interconnection revenue. Voice access lines, including lines acquired, decreased 2.1% from the second quarter of 2005 but increased slightly compared to the first quarter of 2006. Voice access lines, excluding acquired lines, decreased 3.3% from the second quarter of 2005.

Universal Service Fund high cost loop.   Universal Service Fund high cost loop receipts remained flat at $4.7 million in the second quarter of 2006 and 2005.

Interstate access revenues.   Interstate access revenues were $16.6 million for the three months ended June 30, 2006 compared to $20.1 million for the three months ended June 30, 2005. Excluding the impact of acquired companies, interstate access revenues decreased $3.8 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.

Intrastate access revenues.   Intrastate access revenues decreased $0.6 million from $9.5 million in 2005 to $8.9 million in 2006. Excluding the impact of acquired companies, intrastate access revenues decreased $0.9 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 second quarter of 2005. The rate decrease is primarily due to intrastate rate reductions implemented in Maine in the second quarter of 2005. Intrastate revenues are expected to continue to decline.

Long distance services.   Long distance services revenues increased $0.8 million from $4.8 million in 2005 to $5.6 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 June 30, 2006 was 46.8% of voice access lines as compared to 41.7% as of June 30, 2005.

Data and Internet services.   Data and Internet services revenues increased $1.0 million to $6.9 million in 2006 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 40,910 as of June 30, 2005 to 51,331 as of June 30, 2006 and represent a 21.2% penetration of voice access lines.

Other services.   Other revenues increased from $4.2 million in 2005 to $4.9 million in 2006. Excluding the impact of acquired companies, other 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 $1.0 million to $36.3 million in 2006 from $35.3 million in 2005. Approximately $0.9 million of this increase is related to operating expenses of the companies acquired during 2005. In addition, this increase is primarily driven by an increase in salaries and wages of $0.8 million, an increase in expenses related to HSD and long distances services of $0.4 million, an increase in billing expenses of $0.3 million and increases in various other expenses. These increases were offset by a decrease in consulting expenses of

23




$1.7 million due to expenses incurred in 2005 related to our preparation for compliance under Section 404 of the Sarbanes-Oxley Act. 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 June 30, 2006 and 2005, stock based compensation expenses totaled $0.7 million and $0.7 million, respectively.

Depreciation and amortization.   Depreciation and amortization expense increased $0.2 million to $13.4 million in 2006.

Income from operations.   Income from operations decreased $2.2 million to $14.6 million in 2006. This was driven principally by the increased percentage of lower margin unregulated revenues in our total business mix due to DSL and long distance revenue growth, which offset declining higher margin regulated revenues. In addition to the increase in unregulated products, we experienced declines in interstate 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 $17.8 million to $10.2 million in 2006. Gains on sale of investments increased $14.3 million due to the sale of our investments in the Rural Telephone Bank and Southern Illinois Cellular Corporation. Interest and dividend income increased $1.9 million as a result of a dividend distribution from Southern Illinois Cellular Corporation associated with the sale. Interest expense increased $0.2 million to $9.8 million in 2006. Also, in 2005, the redemption of the 12 ½% notes in May 2005 resulted in other non-operating losses of $1.6 million due to fees and penalties paid on the redemption and for the write-off of unamortized debt issuance costs.

Income tax (expense) benefit.   Income tax expense of $9.6 million was recorded for the three months ended June 30, 2006, resulting in an effective rate of 39.0% as compared to 38.5% as of June 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 $15.1 million for the three months ended June 30, 2006 as compared to net income of $5.6 million for the three months ended June 30, 2005. The differences between 2006 and 2005 are a result of the factors discussed above.

24




Six Months Ended June 30, 2006 Compared with Six Months Ended June 30, 2005

 

 

Six months
ended June 30,

 

Six months
ended June 30,

 

 

 

2006

 

% of revenue

 

2005

 

% of revenue

 

 

 

(in thousands)

 

Revenues

 

$

128,987

 

 

100.0

%

 

$

126,871

 

 

100.0

%

 

Operating expenses

 

71,880

 

 

55.7

%

 

67,764

 

 

53.4

%

 

Depreciation and amortization

 

26,987

 

 

20.9

%

 

26,116

 

 

20.6

%

 

Total operating expenses

 

98,867

 

 

76.6

%

 

93,880

 

 

74.0

%

 

Income from operations

 

30,120

 

 

23.4

%

 

32,991

 

 

26.0

%

 

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

 

14,225

 

 

11.0

%

 

(184

)

 

(0.1

)%

 

Interest and dividend income

 

2,927

 

 

2.3

%

 

1,272

 

 

1.0

%

 

Interest expense

 

(19,545

)

 

(15.2

)%

 

(26,558

)

 

(20.9

)%

 

Equity in net earnings of investees

 

6,365

 

 

4.9

%

 

5,452

 

 

4.3

%

 

Other non-operating, net

 

 

 

 

 

(87,746

)

 

(69.2

)%

 

Total other income (expense)

 

3,972

 

 

3.0

%

 

(107,764

)

 

(84.9

)%

 

Income (loss) before income taxes

 

34,092

 

 

26.4

%

 

(74,773

)

 

(58.9

)%

 

Income tax benefit (expense)

 

(13,297

)

 

(10.3

)%

 

91,419

 

 

72.0

%

 

Minority interest in income of subsidiaries

 

(1

)

 

(0.0

)%

 

(1

)

 

0.0

%

 

Net income

 

$

20,794

 

 

16.1

%

 

$

16,645

 

 

13.1

%

 

 

Revenues

Revenues.   Revenues increased $2.1 million to $129.0 million in 2006 compared to $126.9 million in 2005. Excluding the impact of acquired operations, revenues decreased $1.7 million compared to the prior year. We derived our revenues from the following sources:

Local calling services.   Local calling service revenues increased $1.3 million to $32.9 million in 2006 compared to $31.6 million in 2005. Excluding the impact of acquired operations, local calling service revenues increased $0.5 million compared to 2005. The primary driver of this increase is an increase in wireless interconnection revenue. Voice access lines, including lines acquired, decreased 2.1% from June 30, 2005. Voice access lines, excluding acquired lines, decreased 3.3% from June 30, 2005.

Universal Service Fund high cost loop.   Universal Service Fund high cost loop receipts remained flat at $9.5 million in the six month periods ended June 30, 2006 and June 30, 2005.

Interstate access revenues.   Interstate access revenues were $34.2 million for the six months ended June 30, 2006 compared to $37.0 million for the six months ended June 30, 2005. Excluding the impact of acquired companies, interstate access revenues decreased $3.7 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 six months ended June 30, 2006 compared to the six months ended June 30, 2005.

Intrastate access revenues.   Intrastate access revenues decreased $1.8 million to $17.9 million in 2006 compared to 2005. Excluding the impact of acquired companies, intrastate access revenues decreased $2.5 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 2005. The rate decrease is primarily due to intrastate rate reductions implemented in Maine in the second quarter of 2005. Intrastate revenues are expected to continue to decline.

25




Long distance services.   Long distance services revenues increased $1.5 million from $9.5 million in 2005 to $11.0 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 June 30, 2006 was 46.8% of voice access lines as compared to 41.7% as of June 30, 2005.

Data and Internet services.   Data and Internet services revenues increased $2.0 million to $13.6 million in 2006 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 40,910 as of June 30, 2005 to 51,331 as of June 30, 2006 and represents a 21.2% penetration of voice access lines.

Other services.   Other revenues increased from $8.2 million in 2005 to $9.9 million in 2006. Excluding the impact of acquired companies, other revenues increased $0.9 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 $4.1 million to $71.9 million in 2006 from $67.8 million in 2005. Approximately $2.3 million of this increase is related to operating expenses of the companies acquired during 2005. In addition, this increase is primarily driven by an increase in network operations expense of $0.8 million, an increase in billing expenses of $0.8 million, an increase in audit and tax related expenses of $0.6 million, an increase in employee compensation expenses of $0.4 million, an increase in lease expense of $0.3 million and an increase in expenses related to HSD and long distance services of $0.3 million. These increases were offset by a decrease in consulting expenses of $1.8 million due to expenses incurred in 2005 related to our preparation for compliance under Section 404 of the Sarbanes-Oxley Act. Included in operating expenses are non-cash stock based compensation expenses associated with the award of restricted stock and restricted units. For the six months ended June 30, 2006 and 2005, stock based compensation expenses totaled $1.3 million and $1.1 million, respectively.

Depreciation and amortization.   Depreciation and amortization expense increased $0.9 million to $27.0 million in 2006.

Income from operations.   Income from operations decreased $2.9 million to $30.1 million in 2006. This was driven principally by the increased percentage of lower margin unregulated revenues in our total business mix due to DSL and long distance revenue growth, which offset declining higher margin regulated revenues. In addition to the increase in unregulated products, we experienced declines in interstate 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 $111.8 million to $4.0 million in 2006 compared to a loss in the prior year of $107.8 million. Gains on sale of investments increased $14.4 million primarily due to the sale of our investments in the Rural Telephone Bank and Southern Illinois Cellular Corporation. Interest and dividend income increased $1.7 million primarily as a result of a dividend distribution from Southern Illinois Cellular Corporation associated with the sale. Interest expense decreased $7.0 million to $19.5 million in 2006, mainly attributable to the initial public offering and related transactions in 2005 which substantially de-leveraged us and provided a decrease in interest expense. In addition, our series A preferred stock was repurchased which eliminated dividends and accretion on our series A preferred stock for the six months ended June 30, 2006, which under Statement of Financial Accounting Standards No. 150, or SFAS No. 150, were being reported as interest expense. Also, in 2005, in connection with the initial public offering, we repurchased our series A preferred stock and repaid our old credit facility and repurchased or redeemed substantially all of our high yield debt which resulted in significant charges of $87.7 million due to fees and penalties paid on the repurchase/redemption and for the write-off of unamortized debt issuance costs.

26




Income tax (expense) benefit.   Income tax expense of $13.3 million was recorded for the six months ended June 30, 2006, resulting in an effective rate of 39.0%. Exclusive of unusual items affecting the tax rate, our effective annual tax rate was 41.7% as of June 30, 2005.   For the six months ended June 30, 2005, we recorded an income tax benefit of $91.4 million. Following the initial public offering and related transactions, we re-evaluated our expectation of generating future taxable income. Based upon the results of this evaluation, we concluded that we could reverse the deferred tax valuation allowance and, as a result, we recognized income tax benefits of $66.0 million for the six months ended June 30, 2005. Additional income tax benefits of $25.4 million were recognized due to the taxable loss for the six months ended June 30, 2005, which resulted mainly from losses on the extinguishment of debt.

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. As of December 31, 2005, we had $291.9 million of federal and state net operating loss carryforwards. As a result, the income tax expense we record is generally greater than the income taxes actually paid by us.

Net income.   Net income was $20.8 million for the six months ended June 30, 2006 as compared to net income of $16.6 million for the six months ended June 30, 2005. The differences between 2006 and 2005 are a result of the factors discussed above.

Liquidity and Capital Resources

Our short-term and long-term liquidity needs arise primarily from: (i) interest payments primarily related to our credit facility; (ii) capital expenditures; (iii) working capital requirements as may be needed to support the growth of our business; (iv) dividend payments on our common stock; and (v) potential acquisitions. 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 our cash available for distribution to them instead of retaining it in our business.  However, we are not required to pay dividends, and our board of directors may modify or revoke our dividend policy at any time. Dividend payments are within the sole discretion of our board of directors and will depend upon, among other things, our results of operations, our financial condition, future developments that could differ materially from our current expectations, including competitive or technological developments (which could, for example, increase our need for capital expenditures), acquisition opportunities or other factors.

On June 21, 2006, we declared a dividend totaling $13.8 million, or $0.39781 per share of common stock, which was paid on July 21, 2006 to holders of record as of July 6, 2006. In 2006, we have paid dividends totaling $27.6 million, or $0.79562 per share of common stock.

We expect to fund our operations, interest expense, capital expenditures and dividend payments on our common stock for the next twelve months principally from cash from operations and distributions from investments. To fund future acquisitions, we intend to use cash from operations and borrowings under our credit facility, or, subject to the restrictions in our credit facility, proceeds from the sale of non-core assets or to arrange additional funding through the sale of public or private debt and/or equity securities, or obtain additional senior bank debt.

For the six months ended June 30, 2006, cash provided by operating activities of continuing operations was $47.3 million compared to $17.3 million for the six months ended June 30, 2005. The increase in 2006 compared to 2005 is primarily a result of the initial public offering and related transactions in 2005 which substantially de-leveraged us, resulting in a reduction in accrued interest.

Our ability to service our indebtedness depends on our ability to generate cash in the future. We are not required to make any scheduled principal payments under our credit facility’s term facility prior to maturity in February 2012. We will need to refinance all or a portion of our indebtedness on or before maturity. We may not be able to refinance our indebtedness on commercially reasonable terms or at all. If we were unable to renew or refinance our credit facility, our failure to repay all amounts due on the

27




maturity date would cause a default under our credit facility. In addition, borrowings under our credit facility bear interest at variable interest rates.

We have entered into various interest rate swap agreements which are detailed in note 6 of the “Notes to Condensed Consolidated Financial Statements” in this Quarterly Report. As a result of these swap agreements, as of June 30, 2006, approximately 92% of our indebtedness bore interest at fixed rates rather than variable rates. After these interest rate swap agreements expire, our annual debt service obligations on such portion of the term loans will vary from year to year unless we enter into a new interest rate swap or purchase an interest rate cap or other interest rate hedge. To the extent interest rates increase in the future, we may not be able to enter into new interest rate swaps or to purchase interest rate caps or other interest rate hedges on acceptable terms.

Based on the dividend policy with respect to our common stock, we may not have any significant cash available to meet any unanticipated liquidity requirements, other than available borrowings, if any, under our revolving facility. As a result, we may not retain a sufficient amount of cash to finance growth opportunities, including acquisitions, or unanticipated capital expenditures or to fund our operations. If we do not have sufficient cash for these purposes, our financial condition and our business will suffer. However, our board of directors may, in its discretion, amend or repeal the dividend policy to decrease the level of dividends provided for or discontinue entirely the payment of dividends.

As of December 31, 2005 we had $291.9 million of federal and state net operating loss carryforwards. As a result of the utilization of the net operating loss carryforwards we are not paying significant income taxes.

On February 8, 2005, we used net proceeds received from the initial public offering, together with approximately $566.0 million of borrowings under the term facility of our credit facility, to, among other things, repay all outstanding loans under our old credit facility, repurchase all of our series A preferred stock and consummate tender offers and consent solicitations in respect of our outstanding 91¤2% notes, floating rate notes, 121¤2% notes and 117¤8% notes. On March 10, 2005, we redeemed the remaining outstanding 91¤2% notes and floating rate notes. On May 2, 2005, we redeemed the remaining outstanding 121¤2% notes with borrowings of $22.4 million under the delayed draw facility of our credit facility.

Net cash provided by investing activities of continuing operations was $31.5 million for the six months ended June 30, 2006 compared to net cash used in investing activities of continuing operations of $21.4 million for the six months ended June 30, 2005. These cash flows primarily reflect net capital expenditures of $17.5 million and $9.7 million for the six months ended June 30, 2006 and 2005, respectively. Offsetting capital expenditures were distributions from investments of $5.7 million and $4.8 million for the six months ended June 30, 2006 and 2005, respectively, and proceeds from the sale of investments of $43.4 million and $0.2 million for the six months ended June 30, 2006 and 2005, respectively. In April, 2006, we received proceeds of $26.9 million from the liquidation of our investment in the Rural Telephone Bank. In addition, on May 1, 2006, we received proceeds of $14.8 million from the sale of our investment in Southern Illinois Cellular Corp. The distributions from investments represent passive ownership interests in partnership and other investments. We do not control the timing or amount of distributions from such investments. In 2005, we also used $16.4 million in cash to acquire telephone properties.

Net cash used in financing activities of continuing operations was $41.6 million for the six months ended June 30, 2006. Net cash provided by financing activities of continuing operations was $7.7 million for the six months ended June 30, 2005. For the six months ended June 30, 2006, we used cash to pay dividends of $27.6 million and used cash of $14.1 million associated with the net repayment of long term debt. For the six months ended June 30, 2005, net proceeds from the issuance of common stock of $431.9 million was used for the net repayment of long term debt of $209.4 million and the repurchase of preferred and common stock of $129.3 million. Remaining proceeds were used to pay fees and penalties associated with the early retirement of long term debt of $61.0 million, to pay a deferred transaction fee of $8.4 million, to pay debt issuance costs of $8.5 million and to pay dividends of $7.8 million.

28




On July 26, 2006, we completed the purchase of the assets of Cass County for approximately $33.0 million in cash, subject to adjustment. We funded the acquisition from cash on hand and from borrowings under the revolving facility of our credit facility. We expect to fund the acquisition of Unite from cash on hand and from borrowings under the revolving facility of our credit facility.

Our annual capital expenditures for our rural telephone operations have historically been significant. Because existing regulations allow us to recover our operating and capital costs, plus a reasonable return on our invested capital in regulated telephone assets, capital expenditures generally constitute an attractive use of our cash flow. Net capital expenditures were approximately $17.5 million for the six months ended June 30, 2006. We expect total capital expenditures for 2006 to be approximately $29.5 to $31.5 million.

Our credit facility consists of a $100.0 million revolving facility, of which $98.7 million was available at June 30, 2006, that matures in February 2011 and a term facility of $588.5 million, of which $588.5 million was outstanding at June 30, 2006, that matures in February 2012. A $1.3 million letter of credit was also outstanding as of June 30, 2006. On March 11, 2005, April 29, 2005 and September 14, 2005, we entered into amendments to our credit facility. For a summary description of our credit facility, see note 8 of the “Notes to Condensed Consolidated Financial Statements” in this Quarterly Report.

In 2003, the Company issued $225.0 million aggregate principal amount of the 117¤8% notes. These notes were to mature on March 1, 2010. These notes are general unsecured obligations of the Company, ranking pari passu in right of payment with all existing and future senior debt of the Company, including all obligations under our credit facility, and senior in right of payment to all existing and future subordinated indebtedness of the Company. On February 9, 2005, we repurchased $223.0 million principal amount of the 117¤8% notes tendered pursuant to the tender offer for such notes. $2.1 million principal amount of the 117¤8% notes remains outstanding.

Summary of Contractual Obligations

The tables set forth below contain information with regard to disclosures about contractual obligations and commercial commitments.

The following table discloses aggregate information about our contractual obligations as of June 30, 2006 and the periods in which payments are due:

 

 

Payments due by period

 

 

 

Total

 

Less than 
1 year

 

1-3 years

 

3-5 years

 

More than
5 years

 

 

 

(Dollars in thousands)

 

Contractual obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Debt maturing within one year

 

$

696

 

 

$

696

 

 

 

$

 

 

 

$

 

 

$

 

Long term debt

 

592,620

 

 

 

 

 

1,186

 

 

 

2,371

 

 

589,063

 

Operating leases(1)

 

6,405