Hickory Tech 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal period ending December 31, 2007
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 0-13721
HICKORY TECH CORPORATION
(Exact name of registrant as specified in its charter)
221 East Hickory Street
P.O. Box 3248
Mankato, MN 56002-3248
(Address of principal executive offices)
Registrants telephone number, including area code: (800) 326-5789
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act.
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the Act.
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definition of large accelerated filer, accelerated filer, a non-accelerated filer or smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
o Large accelerated filer x Accelerated filer o Non-accelerated filer o Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The number of shares of the registrants common stock, no par value, outstanding as of February 22, 2008 was 13,294,027. The aggregate market value of the registrants common stock held by non-affiliates as of June 29, 2007 was $113,996,847 based on the closing sale price of $9.10 per share on The NASDAQ Global Select Market.
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the Companys Proxy Statement for the Annual Meeting of Shareholders to be held on May 6, 2008 (Proxy Statement) are incorporated by reference in Part III of this Form 10-K.
TABLE OF CONTENTS
The Private Securities Litigation Reform Act of 1995 contains certain safe harbor provisions regarding forward-looking statements. This 2007 Annual Report on Form 10-K (Report) and other documents filed by HickoryTech Corporation under the federal securities laws, including Form 10-Q and Form 8-K, and future verbal or written statements by HickoryTech and its management, may include forward-looking statements. These statements may include, without limitation, statements with respect to anticipated future operating and financial performance, growth opportunities and growth rates, acquisition and divestiture opportunities, business strategies, business and competitive outlook and other similar forecasts and statements of expectation. Words such as expects, anticipates, intends, plans, believes, seeks, estimates, targets, projects, will, may, continues, and should, and variations of these words and similar expressions, are intended to identify these forward-looking statements. Such forward-looking statements are subject to risks and uncertainties that could cause HickoryTechs actual results to differ materially from such statements. These risks and uncertainties include those identified under Part I Item 1A Risk Factors on pages 14 to 24.
Because of these risks, uncertainties and assumptions and the fact that any forward-looking statements made by HickoryTech and its management are based on estimates, projections, beliefs and assumptions of management, they are not guarantees of future performance and you should not place undue reliance on them. In addition, forward-looking statements speak only as of the date they are made. With the exception of the requirements set forth in the federal securities laws or the rules and regulations of the Securities and Exchange Commission, we do not undertake any obligation to update or review any forward-looking information, whether as a result of new information, future events or otherwise.
HickoryTech or the Company refers to Hickory Tech Corporation alone or with its wholly owned subsidiaries, as the context requires. When this report uses the words we, our, or us, it refers to the Company and its subsidiaries unless the context otherwise requires.
HickoryTech is a diversified communications company headquartered in Mankato, Minnesota that leverages over 110 years of experience in the local telephone exchange business. We operate in two principal business segments: the Telecom Sector and the Enventis Sector.
The Telecom Sector is comprised of two service and product lines. The first service and product line is the operation of three local telephone companies or incumbent local exchange carriers (ILECs) and the operation of one telephone company that is a competitive local exchange carrier (CLEC). Our original business, which was formed in 1898, consisted of the operation of a single ILEC. In 1985, we formed HickoryTech Corporation as a holding company for our then current ILECs and to serve as a platform to expand our business. In 1998, we formed the CLEC, which provides the competitive services of long distance, high-speed Internet access (DSL) and digital TV. The second service and product line consists of data processing services, which are sold to the telecommunications industry and are provided through National Independent Billing, Inc., which is a subsidiary of HickoryTech. Prior to 2006, operating results for NIBI had been reported in the Information Solutions Sector, but have been recast to be included in the Telecom Sector to consolidate our reporting for similar operations for all years presented. The primary internal user of NIBI services are the ILECs and CLEC we operate in the Telecom Sector. NIBI activities are of strategic value to HickoryTech, primarily because of the support services it provides to these captive telephone companies. The goals and objectives, and the way that the NIBI product line is run, are closely aligned with those of the Telecom Sector.
We started the operations of our second business segment, the Enventis Sector, when we purchased Enventis on December 30, 2005. Enventis is currently a subsidiary of HickoryTech and is a Minnesota-based regional provider of integrated fiber network, Internet protocol telephony and data services, with 1,500 route miles of fiber network serving business customers in the Upper Midwest. Enventis had formerly been a wholly owned subsidiary of another public corporation.
In December 2006, we sold what had been a third business segment (Enterprise Solutions), which provided telephone, data and Internet protocol equipment sales and service. All financial statements and schedules have been restated to reflect Enterprise Solutions operations as discontinued operations.
Our operations are currently conducted through the following seven subsidiaries:
· Mankato Citizens Telephone Company (MCTC)
· Mid-Communications, Inc. (Mid-Com)
· Heartland Telecommunications Company of Iowa, Inc. (Heartland)
· Cable Network, Inc. (CNI)
· Crystal Communications, Inc. (Crystal)
· National Independent Billing, Inc. (NIBI)
· Enventis Telecom, Inc. (Enventis)
Our core strategy focuses on the offering of integrated communication solutions to businesses and consumers. As we sell integrated bundles of services to our customers, we increase market share, provide additional value and increase customer loyalty.
Our consumer strategy, focused on residential customers, is to market competitive multi-service bundles, which include: DSL, high speed Internet, digital TV, local phone service, long distance and home networking services. We utilize value added services, such as speed, content and features, to differentiate our services in the marketplace. In addition, we intend to provide outstanding customer care in order to win new customers and maintain existing customers. We intend to use the following tactics to achieve this strategy:
· Leverage the HickoryTech brand and its strong reputation in legacy markets to deliver residential solutions,
· Maximize our return in each market we serve by promoting a competitive, multi-service bundle to offer value, competitive pricing, create loyalty and retain customers,
· Increase our digital TV market share by striving to offer customers a competitive entertainment service including customer value added services and flexible channel line-ups, and
· Grow our home networking service in an effort to own the home and provide complete communication services to our residential customers.
Our business-to-business strategies focus on supporting the business customers, ranging from small to large enterprise-sized business. We will offer integrated communication solutions which include Internet protocol telephony, transport, data and network integration services that combine voice and data into a single platform. We intend to differentiate our service offerings by providing our business customers with a fully integrated communications solution that blends our hosted solutions with customer-owned systems. In addition, we will strive to provide unparalleled customer service as a differentiator and we will leverage our Internet protocol expertise both in the metro and out-state areas of Minnesota. We intend to use the following tactics to achieve this strategy:
· Build the Enventis brand to become the regional leader in providing integrated business communication solutions outside of our legacy markets. Leverage the HickoryTech brand and its strong reputation to serve customers within our legacy markets,
· Develop additional service offerings to increase our product portfolio and meet our customers growing communications needs,
· Focus on cross selling all services to existing customers in an effort to maximize our relationship and provide complete solutions,
· Expand business services to targeted new markets along our fiber network,
· Further develop our unified communications product, and
· Leverage our Ethernet service offering and focus on local area network, multi-point sales.
Our wholesale customer strategy focuses on regional and national wireline and wireless carriers, LECs, Internet service providers and data service providers. We intend to leverage our fiber network and provide competitive transport solutions within Minnesota and reaching into Wisconsin, Iowa, North Dakota and South Dakota. We intend to differentiate our service by utilizing a consultative approach in developing innovative and flexible solutions to deliver the best overall value. We intend to leverage our core optical/Internet protocol expertise to deliver and support fully integrated solutions that meet or exceed customer expectations. We intend to use the following tactics to support our wholesale strategy:
· Build the Enventis brand to become the regional leader in providing wholesale solutions,
· Leverage the dense wavelength division multiplexing overlay, multi-protocol label switching overlay and Ethernet capabilities to lead the market with advanced high bandwidth capabilities and services,
· Focus on key wholesale growth verticals such as the wireless sector, data centers, and data local exchange carriers, where we are well positioned to succeed in putting key sites on-net and aggregating out-state connections,
· Focus on the cross-selling of additional services to existing customers in an effort to maximize our relationship and provide those customers with broader solutions, and
· Look for opportunities to increase our carrier interconnections to on-net buildings, central offices and data centers.
Our Information Solutions strategies focus on the support and marketing of SuiteSolution®, which is our branded customer care and billing solution, to the telecommunications industry serving CLECs, LECs, interexchange carriers, wireless and Internet protocol providers, and resellers. Additionally, the Information Solutions division provides internal information technology support across all divisions, enabling us to meet our customers technology and billing needs.
We report the business operations of our three ILECs and CLEC and their associated services along with our data processing (NIBI) services as a single segment that we refer to as the Telecom Sector. The second business segment, Enventis, includes predominately business-to-business operations generally outside of the Telecom Sector service area. The results of operations of the Enterprise Solutions Sector are reported as discontinued operations (see Note 3 to the Notes to the Consolidated Financial Statements).
Our Telecom Sector provides local exchange wireline telephone service, long distance, DSL, digital TV services and owns and operates fiber optic cable facilities. This sector includes three ILECs (MCTC, Mid-Com and Heartland). MCTC and Mid-Com provide telephone service in south central Minnesota, specifically Mankato (a regional hub) and eleven rural communities surrounding Mankato. The third ILEC, Heartland, provides telephone service for eleven rural communities in northwest Iowa. In total, there are twenty-three ILEC exchanges within the Telecom Sector. The Telecom Sector also includes Crystal, a CLEC that provides local telephone service, long distance, DSL and digital TV on a competitive basis. NIBI, which is also part of the Telecom Sector, provides data processing and related services, principally for our affiliated ILECs and CLEC, as well as for other local exchange telephone companies, CLECs, interexchange network carriers, wireless companies and cable TV providers.
We also own and operate fiber optic cable facilities in Minnesota in both our Telecom and Enventis Sectors. These facilities are used to transport interexchange communications as a service to telephone industry customers. Our Minnesota ILECs and CLEC are the primary users of these fiber optic cable facilities in the Telecom Sector. None of the remaining companies in the Telecom Sector experienced major changes in operations during 2007 or 2006, other than the cumulative effect of repeated periodic declines in network access revenue and the gradual erosion of access lines in service, which has reduced the profitability of this Sector. However, the expansion and growth of DSL and broadband services has helped to offset this profitability decline.
MCTC derives its principal revenue and income from local services charged to subscribers in its service area, access services charged to interexchange carriers such as AT&T and the operation of a toll tandem-switching center in Mankato, Minnesota. Revenue and income for Mid-Com are also derived from local service charges in its area of operation and by providing access to long distance services for its subscribers through the toll center in Mankato. Local and interexchange telephone access for the two companies is provided on an integrated basis. The local and interexchange telephone access for both telephone companies utilize the same facilities and equipment and are managed and maintained by a common workforce. Heartland derives its principal revenue and income from local services charged to subscribers in its service area in Iowa, as well as from providing interexchange access for its subscribers. Interexchange telephone access is provided by all three of our ILEC subsidiaries by connecting the communications networks of interexchange carriers and wireless carriers with the equipment and facilities of end users through its switched networks or private lines. Network access revenue accounted for 19.7%, 22.5% and 42.8% of our total revenue in 2007, 2006 and 2005, respectively. The lower percentages in 2007 and 2006 are primarily due to the Enventis acquisition and subsequent operations growth. Without the Enventis Sector, access revenue would have accounted for 40.2% and 39.8% of the total revenue for HickoryTech in 2007 and 2006, respectively.
As local exchange telephone companies, MCTC, Mid-Com and Heartland provide end office switching and dedicated circuits to long-distance interexchange carriers. These relationships allow our telephone subscribers to place long-distance telephone calls to the telephone network. We provide interexchange access to our network for interexchange carriers to conduct long-distance business with individual customers who select a long-distance carrier and for termination of calls to all customers. This interexchange access business is separate and distinct from our own long-distance retail business, which is operated through Crystal. The long-distance interexchange carriers are significant customers of ours, but no carrier represents more than ten percent of our consolidated revenue.
Our ILECs compete with companies that offer private lines to our potential customers in lieu of our switched voice services and with data services in or adjacent to the territories we serve that permit potential customers to bypass local telephone switching facilities. Additionally, services provided by other companies utilizing various Internet, wireline or wireless technologies permit bypass of the local exchange network. Cable TV companies also provide Internet, DSL and voice services in our markets. These alternatives to the local exchange service represent a potential threat to our long-term ability to provide local exchange service at economical rates.
Competition exists for some of the services we provide to interexchange carriers, such as dedicated private lines, network switching and network routing. This competition comes primarily from the interexchange carriers who redirect the services provided by us to their own network or other networks. The provision of these services is primarily month-to-month service ordered from a general tariff, which is a schedule of terms, rates and conditions which are approved by the appropriate state or federal agency. The interexchange carriers primarily control the procurement of these services. As interexchange carriers make these service decisions, they have the potential to reduce our revenue in the Telecom Sector. Other services, such as the provision of broadband, long distance, directory advertising, end user equipment and customer billing services are open to competition.
Specific competition exists in several of our ILEC service areas. A municipality has overbuilt Heartlands network in one community in Iowa and now serves over half of that market. Additionally, cable TV providers are offering voice, Internet and cable TV services in several Heartland, Mid-Com, MCTC and Crystal communities. Our ILECs and CLEC are also periodically engaged in negotiations or renegotiations of arrangements for network interconnections and potential unit price declines with other wireline carriers and various wireless service providers. Although competition from these various sources may result in reduced revenue, we cannot, at this time, estimate the potential impact related to these events or negotiations
Crystal began operations in January of 1998 as a CLEC. Crystal offers local telephone service, long-distance, DSL and digital TV on a competitive basis to customers in Southern Minnesota and Iowa and also connects communications networks of interexchange carriers and wireless carriers with the equipment and facilities of end users. Crystal has customers in ten rural communities, encompassing eight exchanges in Minnesota and three communities encompassing two exchanges in Iowa that are not in the geographies of our ILEC service areas. In addition to these telephone services, Crystal provides long distance service, DSL and digital TV service in eleven communities, including communities served by some of our ILECs. The communities in which Crystal provides digital TV services include St. Peter (initiated in 2001); Waseca (since 2004); New Richland, Ellendale and St. Clair (since 2005); Faribault, Lake Crystal and Eagle Lake (since 2006); and Janesville, North Mankato and Mankato (since 2007), all of which are communities where we provide telephone service either as an ILEC or CLEC.
Crystal is not dependent upon any single customer or small group of customers. No single customer in Crystal accounts for ten percent or more of HickoryTechs consolidated revenue.
NIBIs principal activity is the provision of monthly batch processing of computerized data. Services for our telephone company customers include the processing of long distance telephone calls from data sources and telephone switches, the preparation of subscriber telephone bills, customer record keeping and carrier access bills. There are a number of companies engaged in supplying data processing services comparable to those furnished by NIBI. Competition is based primarily on price and service. NIBI has developed an integrated billing and management system called SuiteSolution®. SuiteSolution® can provide wireline and wireless carriers the individual benefits of a billing platform or a total system solution. SuiteSolution® is comparable in the majority of functional elements to similar products/companies providing end user billing services for small to medium-size independent wireline and wireless service providers in North America. Certain features and functionality of SuiteSolution®, which are based on Request for Proposal responses, are more highly rated than competing products, while other features and functionality may not be as highly rated as competing products. NIBI counts approximately 20 companies as its primary competitors in marketing to small to medium-size independent wireline and wireless service providers in North America. SuiteSolution® does not utilize unique patentable inventions or technological innovations in the construction of the product. Commercially available programming languages are utilized in the development of code that may, based on needs of a prospective user, deliver solutions that are preferred over those of competing products.
We acquired Enventis on December 30, 2005. Through Enventis, we provide integrated data services, offering fiber optic-based communication and advanced data services to business communities in the Upper Midwest. Enventis owns or has long-term leases to approximately 1,500 route miles of fiber optic cable. Enventis also has extensive local fiber optic rings that directly connect the Enventis network with its larger clients (e.g. interexchange carriers, retail, health care, government and education customers, etc.). Other local fiber rings connect the Enventis network to the local telephone enterprises central offices. This allows Enventis to utilize the telephone companys connections to access its smaller clients. Enventis serves customers through interconnections that are primarily leased from third parties (commonly referred to as the last mile). Enventis, through its equipment revenue product line, has business relationships with Cisco Systems, Inc. and is recognized by Cisco as a Gold Partner. The relationship with Cisco Systems, Inc. is a strategic partnership of Cisco (as the supplier) and Enventis (as the distributor). Enventis is a regional leader in deploying leading edge technologies such as Internet protocol call centers. Enventis provides converged Internet protocol services that allow all communications (e.g. voice, video and data) to use the same fiber optic-based delivery technology. Enventis has Minnesota offices located in Plymouth, Duluth and Rochester.
portfolio includes Encompass Unified Communications, which serves
small-to-medium-sized businesses. Encompass is a hosted or managed Internet
protocol communications service including
local and long distance voice; business Internet protocol telephony via a
hosted Internet protocol private branch exchange; unified messaging (a single
inbox for voicemail,
The following summary does not describe all present and proposed federal, state and local legislation and regulations affecting the telecommunications industry. Some legislation and other regulations are currently the subject of judicial proceedings, legislative hearings and administrative proposals that could change the manner in which this industry operates. Neither the outcome of any of these developments nor their potential impact on us can be predicted at this time. Regulation can change rapidly in the telecommunications industry and these changes may have an adverse effect on us in the future. See Risk Factors Risks related to Regulations on pages 17 to 20 for a further discussion of the risks associated with regulatory change.
The services we offer are subject to varying levels of regulatory oversight. Federal and state regulatory agencies share responsibility for enforcing statutes and rules relative to the provision of communications services. Our interstate or international telecommunications services are subject to regulation by the Federal Communications Commission. Intrastate services are governed by the relevant state regulatory commission. The Telecommunications Act of 1996 and the rules enacted under it also gave oversight of interconnection arrangements and access to network elements to the state commissions. Our digital TV services are governed by Federal Communication Commission rules and also on the local level by municipal franchise agreements.
There are also varying levels of regulatory oversight depending on the nature of the services offered or if the services are offered by an incumbent or competitive carrier.
MCTC, Mid-Com and Heartland are incumbent local exchange carriers. MCTC and MidCom are public utilities operating pursuant to indeterminate permits issued by the Minnesota Public Utilities Commission. Heartland is also a public utility, which operates pursuant to a certificate of public convenience and necessity issued by the Iowa Utilities Board. Due to the size of the HickoryTech ILEC companies, neither the Minnesota Public Utilities Commission nor the Iowa Utilities Board regulate their rates of return or profits. In Minnesota, regulators monitor MCTC and Mid-Com price and service levels. Heartland, our Iowa ILEC, is not price-regulated with respect to its local service. Our companies can change local rates by evaluating various factors including economic and competitive circumstances.
Our CLEC businesses provide services in Minnesota, Iowa and Wisconsin with less regulatory oversight than our ILEC companies. A company must file for CLEC or interexchange authority to operate with the appropriate public utility commission in each state it serves. Crystal provides local exchange services in Minnesota and Iowa, and Enventis provides private line services in Minnesota and Wisconsin.
Both Crystal and Enventis offer interexchange carrier services including long-distance that may be regulated at both the federal and state levels. The Federal Communications Commission has authority over interstate and international long-distance services but has chosen to lightly regulate these services in recent years. Long-distance service is subject to consumer protection, complaint-based regulation at the federal level. The regulatory burden is primarily compliance reporting which includes an annual certification of geographical rate averaging and rate integration. In-state long-distance services in Minnesota are regulated by the Minnesota Public Utilities Commission with respect to uniform pricing statewide while in-state long distance services in Iowa are unregulated.
Dial-up access and high-speed Internet access are unregulated at both the state and federal levels.
Crystal competes directly against existing ILECs in the areas in which it operates and also competes directly against incumbent cable TV providers and satellite TV providers for its high speed Internet and digital TV services. Crystal is presently providing these services to eleven Minnesota markets under franchise agreements negotiated with these local municipalities or rural townships.
Federal Regulatory Framework
All carriers must comply with the Federal Communications Act of 1934 as amended, which requires, among other things, that our interstate services be provided at just and reasonable rates and on non-discriminatory terms and conditions. The Federal Communications Act of 1934 also requires Federal Communications Commission approval before we transfer control of our operating companies, assign, acquire or transfer licenses or authorizations issued by the Federal Communications Commission, or before we discontinue any interstate service. The Federal Communications Act of 1934 was amended by the Telecommunications Act of 1996, which has had a dramatic effect on the competitive environment in the telecommunications industry. In addition to these laws, we are also subject to rules promulgated by the Federal Communications Commission and could be affected by any regulatory decisions or orders that they issue.
Access charges refer to the compensation received by local exchange carriers for the use of their networks to originate or terminate interexchange or international calls. We provide two types of access services, which include special access and switched access. Special access is provided through dedicated circuits which connect other carriers to our network. Special access pricing is structured on a flat monthly fee basis. Switched access rates, which are billed to other carriers, are based on a per-minute of use fee basis. The Federal Communications Commission regulates the prices that our ILECs and CLEC charge for interstate access charges. Historically, switched access rates for rural carriers were allowed to be higher than those for larger, more urban companies. This was done to provide a means of implicitly subsidizing the high per-unit cost of local service in rural areas. However, following a series of court cases in 2001, which ruled that subsidies must be explicit rather than implicit, the Federal Communications Commission began to examine various proposals to reform interstate network access rates. One result of those proposals was the lowering of the rates charged to carriers accessing local networks and the application of a subscriber line charge as a flat rate on the end users bills. The lowering of the per minute per use access rate combined with overall lower minutes due to competition, has resulted in a decrease in network access revenue, which may continue.
Each of our ILECs determines its interstate access charges under rate of return regulation, under which they earn a fixed return over and above operating costs. The Federal Communications Commission has established the authorized rate of return at 11.25%. The specific process of setting interstate access rates is governed by part 61.39 of the Federal Communications Commission rules, which applies only to service providers with fewer than 50,000 lines. Two of our ILECs (MCTC and Mid-Com), utilize an average schedule process and the concept of pooling with other ILECs in the National Exchange Carrier Association to arrive at rates and fair compensation.
Our CLECs interstate access rates were established according to an order issued by the Federal Communications Commission in 2001. Under that order, the switched access rates charged by a competitive carrier can be no higher than the rates charged by the incumbent carrier with whom the CLEC competes. Consequently, the rates charged by our facilities-based CLEC for switched access are significantly lower than the rates charged by our ILECs. Because of the emerging nature of the services provided by our other competitive affiliate Enventis, it does not collect access charges from carriers.
In July 2006, the Federal Communications Commission solicited comments on a proposal to reform the interstate access system, now commonly referred to as intercarrier compensation. This proposal is known as the Missoula Intercarrier Compensation Plan, or Missoula Plan. We participate in evaluating and influencing any proposed reforms through our industry associations and affiliations. It is possible that our ILECs could experience a change in revenue if the Missoula Plan were to be adopted by the Federal Communications Commission. There is no definite timeline for the Federal Communications Commission to act in this proceeding however, so it is not possible for us to predict when any change in revenue will occur or the extent of the impact.
The Minnesota Public Utilities Commission has been considering intrastate access reform and universal service for several years. The Minnesota Public Utilities Commission opened two dockets in 2004 regarding state access reform. These dockets were suspended in December 2004 after concerns were expressed by state agencies regarding increases in local rates and the potential that federal activity may also address this issue, and they were officially closed in January 2006. The Minnesota Public Utilities Commission then opened a similar docket on the issue of state access reform and has recently asked for comments to refresh the record. The Iowa Utilities Board had previously not exercised oversight in the access rates of small local exchange carriers. In November of 2007, however, it indicated that it intends to resume that role. We cannot estimate the impact, if any, of future potential state access revenue changes.
In recent years, interexchange carriers and others have become more aggressive in disputing interstate carrier access charges and/or the applicability of access charges to their traffic. A prime example of this is the claim that companies who provide voice communication services over Internet protocol technology are exempt from having to pay access charges. In 2005, the Federal Communications Commission ruled that it was impossible to separate the voice traffic of voice over Internet protocol providers into interstate and intrastate jurisdictions, and therefore such providers would be regulated by the Federal Communications Commission and not by state regulatory commissions. The Federal Communications Commission is currently considering the question of whether or not voice over Internet protocol services are subject to access charges. In the meantime, we believe that long distance and other communication providers will continue to seek to challenge the applicability of access charges either before the Federal Communications Commission or with their local exchange carriers. To date, no long distance or other carriers have made a claim to us contesting the applicability of access charges. We cannot assure you however, that such claims will not be made in the future, nor if such a claim is made, can we estimate the impact.
The U.S. 8th Circuit Court of Appeals has upheld a ruling by the United States District Court, District of Minnesota, in issuing an injunction providing relief from regulation of any service provider of voice over Internet protocol based services in Minnesota. In July 2006, the Federal Communications Commission ruled that voice over Internet protocol services are subject to Federal Universal Service Fund Contributions, but any further regulation of voice over Internet protocol under consideration at the Federal Communications Commission is uncertain. Future decisions regarding the regulation of voice over Internet protocol may result in a change in the business relationship between HickoryTech companies and the interexchange carriers as interconnections with certain voice over Internet protocol providers may not be governed by tariffed access charges. We cannot, at this time, estimate the revenue impact, if any, related to these events.
Due to the combination of rate reforms instituted by the Federal Communications Commission, competitive substitution by wireless and other carriers and customer usage trends, the aggregate amount of interstate network access charges paid by long distance carriers to access providers such as our ILECs and CLEC, has decreased and we project that this will continue. For the year ended December 31, 2007, carrier access revenue, both minutes of use and special access, represented approximately 19.7% of all of our company operating revenue.
Wireline Interstate Our ILEC companies participate in the National Exchange Carrier Association common line pool. End User Common Line funds collected, are pooled and some of our ILEC revenue is based on settlements distributed from the pool. These pool settlements are adjusted periodically. Our ILEC companies do not participate in the National Exchange Carrier Association traffic sensitive pool, but instead, set their own access rates according to the formulas contained in Section 61.39 of the Federal Communications Commission rules and have done this for many years. This biennial rate process was completed in June 2007 and established traffic sensitive interstate rates for the period from June 30, 2007 through July 1, 2009.
Some local exchange carriers have chosen to exit the National Exchange Carrier Association pool under Section 61.39 of the Federal Communication Commission rules, which apply only to service providers with fewer than 50,000 lines. Normally, the National Exchange Carrier Association files interstate access tariffs on behalf of pool members, manages the access revenue pools themselves and distributes the funds. When rural local exchange carriers choose to leave the pool, which they can do for a two-year period, they can set access fees based on their history of calling volumes that differ from National Exchange Carrier Association rates. This results in a higher per minute of use charge. Some companies may then provide service to conference calling companies or other providers who generate a large number of minutes. Such practices have become known in the industry as traffic pumping. These types of business arrangements have been challenged by AT&T with the Federal Communications Commission and by Qwest in the state of Iowa.
The Federal Universal Service Fund was established to overcome geographic differences in costs of providing service and to enable all citizens to communicate over networks regardless of geographical location and or personal income. Prior to the adoption of the Telecommunications Act of 1996, universal service was achieved largely through implicit support subsidies, including federal access charges previously discussed.
The Federal Communications Commission establishes universal service policies at the national level under terms contained in the Telecommunications Act of 1996. The Telecommunications Act of 1996 requires explicit Federal Universal Service Fund mechanisms and enlarged the scope of universal service to include four distinct programs:
· High-Cost program, which subsidizes local carriers operating in high-cost regions of the country to ensure reasonably based telephone rates. This is the program which has the most direct impact on our operating companies,
· Low-Income Subscribers program, which includes the Link Up and Lifeline programs that provide subsidies for service initiation and monthly fees, respectively, with eligibility based on subscriber income,
· Rural Health Care Providers program, which subsidizes telecommunications services used by rural health care providers and provides them with toll free access to an Internet service provider, and
· Schools and Libraries program, also called the E-Rate program, which provides support funding to schools and libraries for telecommunications services, Internet access and internal connections.
The National Exchange Carrier Association collects and disburses Federal Universal Service Fund payments. The National Exchange Carrier Association was formed by the Federal Communications Commission in 1983 following the break-up of AT&T into separate local and long distance operations.
Federal Universal Service Fund payments are only available to carriers that have been designated as Eligible Telecommunications Carriers by a state commission. Each of our ILECs has been designated as an Eligible Telecommunications Carrier. Competitive carriers (CLECs) are also eligible to be designated as Eligible Telecommunications Carrier, provided that they meet the requirements of the program and meet a public interest standard as determined by the appropriate state regulatory agency. CLECs receive support payments based on the support provided to the incumbent carrier in the area in which they serve. Both the Minnesota Public Utilities Commission and Iowa Utilities Board have granted Eligible Telecommunications Carrier status to numerous carriers, including many wireless companies. Under current rules, the payments received by our ILECs are not affected by the payments to the competitive Eligible Telecommunications Carriers. Because of the growing number of competitive Eligible Telecommunications Carriers and the accompanying funds which are being disbursed to them, the Federal Communications Commission is considering several universal service reforms including an interim cap on the Federal Universal Service Fund as it pertains to the competitive carriers.
All Eligible Telecommunications Carriers must certify to their appropriate state regulatory commission that the funds they receive from the Federal Universal Service Fund are being used in the manner intended. The states must then certify to the Federal Communications Commission which carriers have met this standard. That certification is due to the Federal Communications Commission in October of each year in order for carriers to receive funding for the upcoming year. In 2006, both Minnesota and Iowa adopted more stringent guidelines for this determination as recommended by the Federal Communications Commission. To some extent, this increased level of scrutiny puts our receipts of Federal Universal Service Fund payments at risk each year.
There is legislation pending in Congress which would address the Anti-Deficiency Act as it applies to the Federal Universal Service Fund. The Anti-Deficiency Act prevents federal agencies from committing to provide funding in excess of their funds on hand. Currently, the Federal Universal Service Fund administrator makes commitments to fund recipients in advance of collecting the contributions from the carriers that will pay for these commitments. Congress is considering whether to permanently exempt the Federal Universal Service Fund from the Anti-Deficiency Act requirements. If it does not grant this extension however, the Federal Universal Service Fund payments to our companies may be delayed or reduced in the future.
We cannot predict the outcome of any Federal Communications Commission rulemaking or pending legislation. The outcome of any of these proceedings or other legislative or regulatory changes could affect the amount of universal support received by our ILECs. For the year ended December 31, 2007, Federal Universal Service Fund payments represented 4.2% of our telecom revenue and 2.1% of our total revenue.
Regulation of the Internet
In an order released on September 23, 2005, the Federal Communications Commission adopted a comprehensive regulatory framework for facilities-based providers of wireline broadband Internet access services (the WBBO). The Federal Communications Commission determined that facilities-based wireline broadband Internet access is an information service, and not a telecommunications service. This designation positioned the high-speed DSL Internet access offered by price cap telcos and CLECs on the same regulatory footing as cable modem service. Following a transitional period, which has passed, facilities-based wireline carriers are no longer obligated to provide broadband Internet access transmission to unaffiliated Internet service providers. In addition, the WBBO allowed for the provision of wireline broadband Internet access on a common carrier, or non-common carrier basis. Our CLEC DSL service in our CLEC markets is provided on a non-common carrier basis. We have determined it is in the best interest of our ILEC companies to continue to offer DSL on a tariffed, common-carrier basis however. As our circumstances continue to shift, we also continue to re-evaluate our options.
The Telecommunications Act of 1996 and Local Competition
The primary goal of the Telecommunications Act of 1996 and the Federal Communications Commissions rules promulgated under it was to open local telecommunications markets to competition while enhancing universal service. To some extent, Congress pre-empted the local authority of states to oversee local telecommunications services.
The Telecommunications Act of 1996 imposes a number of requirements on all local telecommunications providers which include:
· To interconnect directly or indirectly with other carriers,
· To allow others to resell their services,
· To provide for number portability, which allows end users to retain their telephone number when changing providers,
· To ensure dialing parity,
· To ensure that competitors customers have nondiscriminatory access to telephone numbers, operator services, directory assistance and directory listing services,
· To allow competitors access to telephone poles, ducts, conduits and rights-or-way, and
· To establish reciprocal compensation arrangements for the transport and termination of telecommunications traffic.
Local Number Portability In 2003, the Federal Communications Commission released a decision providing guidance on porting between wireline and wireless networks (inter-modal porting). All of the Companys wireline operations have operated with local number portability capabilities since early 2005. Although the effects of inter-modal porting on our wireline operations have been minimal to date, it is possible that these requirements could adversely affect our wireline operating costs and customer growth rates. We are unable to quantify the long-term effects or revenue impact of wireline customers that may switch to wireless or other wireline alternatives.
Unbundling - There is another tier of requirements under the Telecommunications Act of 1996 which apply to incumbent carriers that are not designated as rural telephone companies. Each of our ILECs is a rural telephone carrier and this designation can only be removed by a petition of a competing carrier to the state regulatory commission. As no one has challenged our designation, our ILECs have not yet had to meet these requirements. If this designation was removed, our ILECs would be required to:
· Provide non-discriminatory access to discrete parts of the network, such as local loops and transport facilities. This is referred to as Unbundled Network Elements, and
· Providing, at rates, terms and conditions that are just, reasonable and non-discriminatory, for the physical co-location of equipment necessary for interconnection or access to unbundled network elements.
The unbundling requirements of the Telecommunications Act of 1996 have been some of the most controversial provisions of the act and the rules implementing them have been revised by the Federal Communications Commission over the years. While our ILECs have not been required to un-bundle their networks, our CLEC operating entities have taken advantage of the unbundling and co-location requirements and currently purchase both in territories served by Qwest Communications.
Under the direction of Congress, the Federal Communications Commission is required to revisit the unbundling requirements every three years. Under the Triennial Review process, certain unbundled network elements are now no longer available. We have not been affected by those decisions. There are other processes available for incumbents to limit the network elements they must un-bundle. One process calls for a petition to the state regulatory commission to determine if particular central offices are no longer impaired. This impairment threshold, initially established by the Federal Communications Commission, indicates that if three or more facilities-based providers are offering special access services in a geographical area, then the area is not impaired absent access to unbundled services from the incumbent. The requirement to provide those unbundled network elements is then removed from the incumbent for that area. There is currently such a petition before the Minnesota Public Utilities Commission for review of several exchanges. We do not anticipate any impact from this eventual decision as the affected unbundled network elements are not ones which we purchase.
A related issue is a forbearance procedure whereby an ILEC may petition the Federal Communications Commission to forbear from applying unbundling requirements if they show a threshold level of competition. On April 27, 2007, Qwest Communications filed such a petition for the Minneapolis-St. Paul metropolitan statistical area (Federal Communications Commission Wireline Competition Bureau Docket 07-97). Again, purchases of unbundled network elements in this metropolitan statistical area have not been an extensive component of our CLECs business plan, so we do not anticipate that a decision will affect our current plans, though it could affect future strategic planning.
We employ approximately 400 employees, most of whom are based in Minnesota. A total of approximately 270 employees are located at our headquarters in Mankato, Minnesota. We have a collective bargaining agreement with the International Brotherhood of Electrical Workers Local 949, which covers approximately 92 of our employees. There have been no work stoppages or strikes by our International Brotherhood of Electrical Workers Local 949 employees in the past 30 years and we consider our labor relations to be good.
We believe we have trademarks, trade names and licenses that are necessary for the operation of our business as we currently conduct it. The HickoryTech logo is a registered trademark of the United States. We do not consider our trademarks, trade names or licenses to be material to the operation of our business.
Available Information and Website Access to Securities and Exchange Commission Reports
Our Internet website is located at http://www.hickorytech.com. Information contained in our website is not part of this Form 10-K.
Copies of our most recent Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, can be obtained, free of charge, as soon as reasonably practical after such material is electronically filed, or furnished to the Securities and Exchange Commission. To obtain this information visit our website noted above and click on Investor Relations, or call 507-387-3355, or write a request addressed to:
PO Box 3248
221 East Hickory Street
Mankato, MN 56002-3248
Code of Ethics and Code of Conduct
Our board of directors has adopted a Code of Ethics that is applicable to all directors, the chief executive and chief financial officers, to employees involved in financial reporting, and to other designated employees. All employees of the Company have adopted a Code of Conduct and have undergone training on this code and ethics. Our Board of Directors has also adopted written charters for its committees that comply with the NASDAQ Global Select Market. Copies of the committee charters are available on our website or upon request by contacting our Investor Relations department at 507-387-3355 or by writing the Investor Relations department at the address noted above.
Our businesses face many risks, the most important of which we attempt to describe below. If any of the events or circumstances described in the following risks actually occurred, our business financial condition or results of operations may suffer and impact the trading price of our stock.
Risks Related to Our Business
The telecommunications industry is generally subject to substantial regulatory changes, rapid development and introduction of new technologies and intense competition that could cause us to suffer price reductions, reduced operating margins or loss of market share. The telecommunications industry has been, and we believe will continue to be, characterized by several trends, including the following:
· Substantial regulatory change due to the passage and implementation of the Telecommunications Act of 1996, which included changes designed to stimulate competition for both local and long distance telecommunications services,
· Rapid development and introduction of new technologies and services,
· Increased competition within established markets from current and new market entrants that may provide competing or alternative services,
· The blurring of traditional dividing lines between, and the bundling of, different services, such as local dial tone, long distance, wireless, cable TV, data and Internet services, and
· An increase in mergers and strategic alliances that allow one telecommunications provider to offer increased services or access to wider geographic markets.
The telecommunications industry is highly competitive. The Telecommunications Act of 1996 permitted competition among communication companies for the rights to interconnect with established networks and to establish new networks in order to offer telephone service to customers in a franchised area. We serve as an ILEC in a number of franchised areas, as well as a CLEC in a number of markets. Other telecommunications carriers have the authority under this legislation to provide new networking routes, points of interconnection, technology or signaling protocol, creating competition, which could have a material adverse affect on our profitability. Many of our voice and data competitors, such as cable TV providers, Internet access providers, wireless service providers and long distance carriers, have brand name recognition and financial, personnel, marketing and other resources that are significantly greater than ours. In addition, due to consolidation and strategic alliances within the telecommunications industry, we cannot predict the number of competitors that will emerge, especially as a result of existing or new federal and state regulatory or legislative actions. Such increased competition from existing and new entities could lead to price reductions and reduced operating margins or loss of market share. Although we attempt to differentiate our products and service through technology, reputation and price, competition has increased in the majority of the markets that we serve. This competition has impacted our profitability in the past and we cannot assure you that it will not continue to impact our profitability in the future.
We may not accurately predict technological trends or the success of new products in these markets. New product development often requires long-term forecasting of market trends, development and implementation of new technologies and processes and substantial capital investment. If we fail to anticipate or respond in a cost-effective and timely manner to technological developments, changes in industry standards or customer requirements, our business, operating results and financial condition could be materially adversely affected.
We may not be able to successfully introduce new products and services. Our success depends, in part, upon our ability to successfully introduce new products and services, our ability to offer bundled service packages on terms attractive to our customers, our ability to expand our long distance, Internet, and digital TV offerings to new markets, our ability to introduce and distribute the equipment and systems of manufacturers of switching equipment and the suppliers of communications technology compared to the competitive alternatives of other suppliers, our ability to provide transport solutions and competitive Internet protocol services, including telecommunications and network solutions, and the ability of our CLEC business to provide competitive local service in new markets.
Shifts in our product mix may result in declines in operating profitability. Our traditional ILEC services carry higher margins than many of the newer services. Changes in product mix may also cause some of our inventory to become obsolete. We currently manage potential obsolescence through reserves, but future technology changes may exceed current reserves.
Consolidation among our customers could result in our losing customers or experiencing a slowdown as integration takes place. Consolidation may impact our business as our customers focus on integrating their operations. We believe that in certain instances, customers engaged in integrating large-scale acquisitions may scale back their purchases of network equipment and network services while the integration is ongoing. Further, once consolidation occurs, our customers may choose to reduce the number of vendors they use to source their equipment or consolidate their circuits or network routing. After a consolidation occurs, there can be no assurance that we will continue to supply equipment or network services to the surviving communications service provider. The impact of significant mergers on our business is likely to be unclear until sometime after such transactions have closed.
We depend on third parties, over whom we have no control, to deliver our services. Because of the interconnected nature of the communications industry, we depend heavily on other telecommunications companies, network providers, program service providers and equipment vendors to deliver our services. In addition, we are dependent on easements, franchises and licenses from various private and public entities in order to construct and to operate our networks. The failure to maintain these necessary third party arrangements on acceptable terms would have an adverse effect on our ability to conduct our business.
Our possible pursuit of acquisitions could be expensive, may not be successful and, even if successful may be more costly than anticipated. Our acquisition strategy entails numerous risks. The pursuit of acquisition candidates could be expensive and may not be successful. Our ability to complete future acquisitions will depend on our ability to identify suitable acquisition candidates, negotiate acceptable terms for their acquisition and, if necessary, finance those acquisitions, in each case, before any attractive candidates are purchased by other parties, some of whom may have greater financial resources than us. Whether or not any particular acquisition is closed successfully, each of these activities is expensive and time consuming and would likely require our management to spend considerable time and effort to accomplish them, which would detract from their ability to run our current business. We may face unexpected challenges in receiving any required approvals from the Federal Communications Commission or other applicable state regulatory commissions, which could result in delay or our not being able to consummate the acquisition. Although we may spend considerable expense and effort to pursue acquisitions, we may not be successful in closing them.
If we are successful in closing any acquisitions, we would face several risks associate with integration. In addition, any due diligence we perform may not prove to have been accurate. For example, we may face unexpected difficulties in entering markets in which we have little or no direct experience or in generating unexpected revenue and cash flow from the acquired companies or assets.
If we do pursue an acquisition or other strategic transactions and any of these risks materialize, they could have a material adverse effect on our business and our ability to achieve sufficient cash flow, provide adequate working capital, service and repay our indebtedness and leave sufficient funds to pay dividends.
Risks Related to the Management of Our Operations
A failure in our operational systems or infrastructure could impair our liquidity, disrupt our business, damage our reputation and cause loss. Shortcomings or failures in our internal processes, people or systems could impair our liquidity, disrupt our business, result in liability to customers or regulatory intervention, damage our reputation or result in financial loss. For example, our telephone operations rely on a central switch to complete local and long distance phone calls to various customers. An interruption in the switch operations could lead to interrupted service for customers. To be successful, we will need to continue providing our customers with a reliable and secure network. Disruptions or system failures may cause interruptions in service or reduced capacity for customers. In addition, our financial, accounting, data processing or other operating systems and facilities may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, thereby adversely affecting our ability to process transactions. Our inability to accommodate an increasing volume of transactions could constrain our ability to increase revenue and expand our businesses. Despite the existence of contingency plans and facilities, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which these businesses are located.
We operate our network and our business under contracts and franchises that are subject to non-renewal or termination. Our network operates pursuant to franchises, permits or rights from public and private entities, which are terminable if we fail to comply with material terms of the authority we receive. These permits, and many contracts we utilize in our network, have fixed terms and must be renewed periodically. Our success is dependent on continuing these relationships without material increase in our expenses or restrictions on our use.
Our businesses may be adversely affected if we are unable to hire and retain qualified employees. Our performance is largely dependant on the talents and efforts of highly skilled individuals in the operations of our telecommunication businesses, including telephone operations, billing software development and telecommunications equipment sales and service. Technological advances require our employees to upgrade their knowledge base continually. Our ability to compete and grow our business effectively depends upon our ability to attract qualified employees and retain and motivate our existing employees. In addition, we may acquire new businesses in the future and our success will depend, in part, upon our ability to retain and integrate personnel from acquired businesses, who are critical to the continued success or the successful integration of these acquired businesses.
We may have unanticipated increases in capital spending, operating or administrative costs, or seek new business opportunities that require significant up-front investments. We operate in cash-flow-dependent businesses. Our existing networks require large capitalized up-front investments for growth and maintenance. Our operating expenses in the form of payroll for a highly trained workforce and the maintenance cost of telecommunications networks are large uses of cash. Our debt service obligation and our dividends to shareholders also require significant cash each year. New business development may require additional up-front investment in assets and funding of early stage operating losses. We have business plans which provide adequate sources of cash from operations to fund these endeavors, and we select the balance of old and new business to appropriately fund the Company. The risk is from any sudden unanticipated increases in cash outflow after we have already initiated our business plans. If this were to happen, we would alter our future business plans, which could possibly affect our growth or ability to maintain our current network infrastructure.
Employee misconduct is difficult to detect and prevent, and could have an adverse effect on our business. Although we have not experienced any significant employee misconduct to date, there have been a number of highly publicized cases with other companies involving fraud or other misconduct by employees in recent years, and we may run the risk that employee misconduct could occur. It is not always possible to deter or prevent employee misconduct and the precautions that we take to prevent and detect this activity may not be effective in all cases.
Risks related to Regulations
The telecommunications industry in which we operate is subject to extensive federal, state and local regulation that could change in a manner adverse to us. Our local telephone businesses in Minnesota and Iowa are a significant source of our revenue and free cash flow. The laws and regulations governing these businesses may be, and in some cases have been, challenged in the courts and could be changed by Congress, state legislatures or regulators at any time. In addition, new regulations could be imposed by federal or state authorities increasing our operating costs or capital requirements or that are otherwise adverse to us. We cannot predict the impact of future developments or changes to the regulatory environment or the impact such developments or changes may have on us. Adverse rulings, legislation or changes in governmental policy on issues material to us could increase our competition, cause us to lose customers to competitors and decrease our revenue, increase our costs and decrease our profitability.
Legislative or regulatory changes and technological advances could reduce the revenue our ILEC and CLEC operations receive from network access charges. Access charges, which are intended to compensate our ILEC and CLEC operations for originating, terminating or transporting long distance and other carriers calls in our service areas, accounted for approximately 19.7% of our total revenue in 2007. The amount of network access charges we receive is based on interstate rates set by the Federal Communications Commission and intrastate rates set by the Minnesota Public Utilities Commission and the Iowa Utilities Board. The large national carriers who pay these charges have advocated in the past that access charges should be reduced and some network providers have argued that access charges do not apply to specific types of their traffic. Emerging technologies, such as voice over Internet protocol, have caused a debate about whether access charges apply. As our business becomes increasingly competitive, the regulatory disparities regarding network access revenue, the marketplace forces on its pricing levels and our ability to enforce the historical rules for collecting this revenue, could have a material adverse effect on our business. We cannot predict whether or when action may be taken on any of these issues, or what effect any action may have on revenue and costs of our ILEC and CLEC operations.
Traditionally, regulators have allowed network access rates to be set higher in rural areas in relation to the actual cost of originating or terminating calls as an implicit means of subsidizing the high cost of providing rural service. In 2001, the Federal Communications Commission adopted rules reforming the network access charge system for rural carriers, including reductions in per-minute access charges and increases in both, Federal Universal Service Fund subsidies and flat-rate monthly per line charges on end-user customers. The Federal Communications Commission is currently considering more changes in network access charges. Depending on the Commissions decisions, our current network access charge revenue could be reduced materially and we do not know whether increases in other revenue, such as federal subsidies and monthly line charges, will be sufficient to offset any such reductions or if competitive pressures will allow increases. The Minnesota Public Utilities Commission and Iowa Utilities Board may make changes in our intrastate network access charges, which may also cause reductions in our revenue. To the extent any of our companies become subject to competition, a portion of long distance and other carriers network access charges will be paid to our competitors rather than to our companies. In addition, the compensation our companies receive from network access charges could be reduced due to competition from wireless carriers to a greater extent than historically.
We believe that there has been a general increase in the unauthorized use of telecommunications providers networks without payment of appropriate access charges, or so-called phantom traffic, due in part to advances in technology that have made it easier to use networks while also avoiding payment for the traffic. As a general matter, we believe this phantom traffic is due to unintended usage and, in some cases, fraud. We cannot assure you that there will not be material claims made against us contesting the applicability of network access charges billed by our ILEC and CLEC operations or continued or increased phantom traffic that uses our network without paying us for it. If there is a successful dispute or avoidance of the applicability of network access charges, our revenue could decrease.
Legislative or regulatory changes could reduce or eliminate the government subsidies we receive. The federal system of subsidies, from which we derive a significant portion of our revenue, is subject to modification. Our ILEC and CLEC operations receive significant federal subsidy payments.
· For the year ended December 31, 2007, we received an aggregate of $3,268,000 from the Federal Universal Service Fund, which comprised 2.1% of our revenue for the year.
· For the year ended December 31, 2006, we received an aggregate of $2,495,000 from the Federal Universal Service Fund, which comprised 1.9% of our revenue for the year.
· For the year ended December 31, 2005, we received an aggregate of $2,345,000 from the Federal Universal Service Fund, which comprised 3.0% of our revenue for the year.
During the last two years, the Federal Communications Commission has made modifications to the Federal Universal Service Fund system that changed the sources of support and the method for determining the level of support to Federal Universal Service Fund recipients. It is unclear whether the changes in methodology will continue to accurately reflect the costs incurred by our ILEC operations and whether we will continue to receive the same amount of Federal Universal Service Fund support that we have received in the past. The Federal Communications Commission is also currently considering a number of issues regarding the source and amount of contributions to, and eligibility for payment from, the Federal Universal Service Fund, and these issues may also be the subject of legislative amendments to the Telecommunications Act of 1996.
In December 2007, Congress suspended the application of a law called the Anti-Deficiency Act until December 31, 2008. The Anti-Deficiency Act prohibits government agencies from making financial commitments in excess of their funds on hand. Currently, the Federal Universal Service Fund administrator commits to fund recipients in advance of collecting the contributions from carriers that will pay for these commitments. The Federal Communications Commission has not determined whether the Anti-Deficiency Act would apply to payments to our ILEC operations. Congress is now considering whether to extend the current temporary legislation that exempts the Federal Universal Service Fund from the Anti-Deficiency Act. If it does not grant this extension, however, our Federal Universal Service Fund subsidy payments may be delayed or reduced. We cannot predict the outcome of any federal or state legislative action or any Federal Communications Commission, Minnesota Public Utilities Commission or Iowa Utilities Board rulemaking or similar proceedings. If we do not continue to receive federal and state subsidies, or if these subsidies are reduced, our ILEC operations will likely have lower revenue and may not be able to operate as profitably as they have historically.
In addition, under the Telecommunications Act of 1996, our competitors may obtain the same level of Federal Universal Service Fund subsidies we do if the Minnesota Public Utilities Commission or Iowa Utilities Board, as applicable, determines that granting these subsidies to competitors would be in the public interest and the competitors offer and advertise certain telephone services as required by the Telecommunications Act of 1996 and the Federal Communications Commission. Under current rules, any such payments to our competitors would not affect the level of subsidies received by our ILEC and CLEC operations, but they would facilitate competitive entry into our ILEC and CLEC service areas and we may not be able to compete as effectively or otherwise continue to operate as profitably.
Legislative and regulatory changes in the telecommunications industry could raise our costs by facilitating greater competition against us and reduce potential revenue. Legislative and regulatory changes in the telecommunications industry could adversely affect our business by facilitating greater competition against us, reducing our revenue or raising our costs. For example, federal or state legislatures or regulatory commissions could impose new requirements relating to standards or quality of service, credit and collection policies, or obligations to provide new or enhanced services such as high-speed access to the Internet or number portability, whereby consumers may keep their telephone number when changing carriers. Any such requirements could increase operating costs or capital requirements.
The Telecommunications Act of 1996 provides for significant changes and increased competition in the telecommunications industry. This federal statute and the related regulations remain subject to judicial review and additional rulemakings of the Federal Communications Commission, as well as to implementing actions by state commissions.
Currently, there exists only a small body of law and regulation applicable to access to, or commerce on, the Internet. As the significance of the Internet expands, federal, state and local governments may adopt new rules and regulations or apply existing laws and regulations to the Internet. The Federal Communications Commission is currently reviewing the appropriate regulatory framework governing broadband consumer protections for high-speed access to the Internet through telephone and cable TV providers communications networks. The outcome of these proceedings may affect our regulatory obligations and costs and competition for our services which could have a material adverse effect on our revenue.
Our operations and properties are subject to federal, state and local laws and regulations relating to the protection of the environment, natural resources and worker health and safety that could adversely affect our profitability. We operate under a number of environmental and health and safety laws, including laws and regulations governing and creating liability to, the management, storage and disposal or hazardous materials, asbestos, petroleum products and other regulated materials. We are subject to environmental laws and regulations governing air emissions from our fleets of vehicles. As a result, we face several risks, including the following:
· Under certain environmental laws, we could be held liable, jointly and severally and without regard to fault, for the costs of investigating and the remediation of any actual or threatened environmental contamination at currently and formerly owned or operated properties, and those of our predecessors, and for contamination associated with disposal by us or our predecessors of hazardous materials at third party disposal sites,
· The presence of contamination can adversely affect the value of or properties and our ability to sell any such affected property or to use it as collateral,
· We could be held responsible for third party property damage claims, personal injury claims or natural resource damage claims relating to any such contamination,
· The cost of complying with existing environmental requirements could be significant,
· Adoption of new environmental laws or regulations or changes in existing laws or regulations or their interpretations could result in significant compliance costs or as yet identified environmental liabilities,
· Future acquisition of businesses or properties subject to environmental requirements or affected by environmental contamination could require us to incur substantial costs relating to such matters, and
· In addition, environmental laws regulating wetland, endangered species and other land use and natural resource issues may increase costs associated with future business or expansion opportunities, delay, alter or interfere with such plans, or otherwise adversely affect such plans.
A lack of parity between us and our competitors concerning assessments and tax laws could adversely impact our ability to profitably compete. The telecommunications industry is heavily taxed and assessed. As regulated entities, we serve as the pass-through entity responsible for charging and collecting the fees and taxes from our end-user customers and remitting the monies collected to the taxing and regulatory authorities. Unless regulators and taxing authorities change or clarify their rules and regulations to include our competitors, or deregulate and exclude us, the lack of parity could adversely impact our ability to effectively compete on price.
The high costs of regulatory compliance could make it more difficult for us to enter new markets, make acquisitions or change our prices. Regulatory compliance results in significant costs for us and diverts the time and effort of our management and officers away from running the business. In addition, because regulations differ from state to state, we could face significant costs in obtaining information necessary to compete effectively if we try to provide services, such as long distance services, in different states. These information barriers could cause us to incur substantial costs and to encounter significant obstacles and delays in entering these markets. Compliance costs and information barriers could also affect our ability to evaluate and compete for new opportunities to acquire local access lines or businesses as they arise.
Our intrastate services are also generally subject to certification, tariff filing and other ongoing state regulatory requirements. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses. If successful, these challenges could adversely affect the rates that we are able to charge to customers, which would negatively affect our revenue.
Risks Related to Our Indebtedness and Our Capital Structure
We have a large balance of senior bank debt outstanding and may incur additional indebtedness in the future, which could restrict our ability to pay dividends and fund our operations. We have senior bank debt outstanding under long-term financing agreements. As of December 31, 2007, we had $129,206,000 of total long-term debt outstanding, including current maturities, and $31,932,000 of stockholders equity. The degree to which we are leveraged could have important consequences including:
· Requiring us to dedicate a substantial portion of our cash flow from operations to make principal and interest payments on our debt. These payments are currently expected to be approximately $9,225,000 in 2008 and have been incorporated into our historical cash flow plans. To the extent that future principle and interest payments change significantly, it could affect our future planning, thereby reducing funds available for current operations, future business operations and other purposes, and/or dividends on our common stock,
· Limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate,
· Making it more difficult for us to satisfy our debt and other obligations,
· Limiting our ability to borrow additional funds, or to sell assets to raise funds, if needed, for working capital, capital expenditures, acquisitions or other purposes,
· Increasing our vulnerability to general adverse economic and industry conditions, including changes in interest rates, and
· Placing us at a competitive disadvantage compared to our competitors that have less debt.
We cannot assure you that we will generate sufficient revenue to service and repay our debt and have sufficient funds left over to achieve or sustain profitability in our operations, meet our working capital and capital expenditure needs, compete successfully in our markets or pay dividends to our stockholders.
If we seek additional financing, we may not be able to obtain it. Also, if we are able to secure additional financing, our shareholders may experience dilution of their ownership interest or we may be subject to limitations on our operations. We currently anticipate that our available cash resources, which include our credit facility, existing cash, cash equivalents and available-for sale securities, will be sufficient to meet our anticipated needs for working capital and capital expenditures to execute our near-term business plan, based on current business operations and economic conditions. If our estimates are incorrect and we are unable to generate sufficient cash flows from operations and we expend our credit facility, we may need to raise additional funds. In addition, if one or more of our strategic acquisition opportunities exceeds our existing resources, we may be required to seek additional capital. If we raise additional funds through the issuance of equity or equity-related securities, our shareholders may experience dilution of their ownership interests and the newly issued securities may have rights superior to those of common stock. Our existing debt covenants require a portion of the proceeds of an equity offering be applied to the outstanding debt balance. If we raise additional funds by issuing additional debt, we may be subject to restrictive covenants that could limit our operating flexibility, and increased interest payments could dilute earnings per share.
We are subject to risks associated with changes in interest rates. We currently expect our cash interest expense to be approximately $8,494,000 in 2008. We face market risks from changes in interest rates that could affect our results of operations and financial condition adversely. Although we attempt to reduce this risk through the use of derivative financial instruments, we do not enter into derivative instruments for the purpose of speculation. We have entered into an interest rate protection agreement on approximately $60,000,000 of our variable-interest rate debt, which has a remaining maturity of twenty-four months, in order to manage our exposure to interest rate movements. If interest rates fail to rise as anticipated when the instruments were acquired, we will experience higher-than-market-rate interest expense and would have paid for protection that wasnt needed. We also risk entering a higher interest rate environment when the interest rate protection agreements expire in 2010. This could affect our future interest expense level. In addition, we have a fixed interest rate lock on $19,000,000 of our variable interest rate debt, which expires in 2008. We are subject to the same positive or negative impacts relative to variable rate alternatives as described above for our use of derivative instruments.
Risks Related to Financial Aspects of Our Company
Customer payment defaults could have an adverse effect on our financial condition and results of operations. As a result of adverse market conditions, some of our customers may experience serious financial difficulties. Some of the interexchange carriers and long distance companies that utilize our network are our largest customers when it comes to recurring revenue. In some cases these difficulties have resulted or may result in bankruptcy filings or cessation of operations. If customers experiencing financial problems default on amounts owed to us, we may not be able to recognize expected revenue. Although we currently manage this exposure through an allowance for doubtful accounts, an unexpected bankruptcy or default by a customer may not be fully reserved in our allowance. In addition, it may become necessary for us to offer equipment financing to some of our customers in the future to remain competitive. If we offer such financing it would be our intent to sell all or a portion of the financing receivables to third parties. In the past, we have sold some receivables with recourse and have had to compensate the purchaser for the related losses.
A failure to maintain effective internal controls could adversely affect our business. Although we have completed the documentation and testing of the effectiveness of our internal control over financial reporting for fiscal 2007, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we expect we will have to incur continuing costs, which may include increased accounting fees and increased staffing levels, in order to maintain compliance with that section of the Sarbanes-Oxley Act. In addition, our ability to integrate the operations of other companies that we may acquire in the future could impact our compliance with Section 404. In the future, if we fail to complete the Sarbanes-Oxley 404 evaluation in a timely manner, or if our independent registered public accounting firm cannot attest in a timely manner to the effectiveness of our internal controls, we could be subject to regulatory scrutiny and a loss of public confidence in our internal controls. In addition, any failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause us to fail to meet our reporting obligations.
Risks Related to Our Common Stock
Our board of directors could, in its discretion, depart from or change our dividend payment practices at any time. We are not required to pay dividends and our stockholders are not guaranteed, and do not have contractual or other rights, to receive dividends. Our board of directors may decide at any time, in its discretion, to decrease the amount of dividends, otherwise change or revoke our past dividend payment practices or discontinue entirely the payment of dividends. In addition, if we do not pay dividends for whatever reason, your shares of our common stock could become less liquid and the market price of our common stock could decline.
Our ability to pay dividends, and our board of directors determination to maintain our past dividend payment practices, will depend on numerous factors, including the following:
· The state of our business, the environment in which we operate and the various risk factors we face, including, but not limited to competition, technological change, changes in our industry, regulatory and other risks summarized in this Annual Report on Form 10-K,
· Our future results of operations, financial condition, liquidity needs and capital resources,
· Our cash needs, including interest and any future principal payments on our indebtedness, capital expenditures, taxes, pension and other post-retirement contributions and certain other costs, and
· Potential sources of liquidity, including borrowing under our revolving credit facility or possible asset sales.
While our cash flow available to pay dividends for the year ended December 31, 2007 was sufficient to pay dividends in accordance with our past dividend payment practices, if our estimated cash flow available to pay dividends were to fall below our expectations, our assumptions as to estimated cash needs are too low or if other applicable assumptions were to prove incorrect, we may need to:
· Either reduce or eliminate dividends,
· Fund dividends by incurring additional debt (to the extent we were permitted to do so under agreements governing our then existing debt), which would increase our leverage, debt repayment obligations and interest expense and decrease our interest coverage, resulting in, among other things, reduced capacity to incur debt for other purposes, including to fund future dividend payments,
· Amend the terms of our credit agreement, if our lenders agreed, to permit us to pay dividends or make other payments if we are otherwise not permitted to do so,
· Fund dividends from future issuances of equity securities, which could be dilutive to our stockholders and negatively affect the price of our common stock,
· Fund dividends from other sources, such as by asset sales or by working capital, which would leave us with less cash available for other purposes, and
· Reduce other expected uses of cash, such as capital expenditures.
If we continue to pay dividends at the level currently anticipated under our current dividend payment practices, our ability to pursue growth opportunities may be limited. We believe that our current dividend payment practices could limit, but not preclude, our ability to grow. If we continue paying dividends at the level currently anticipated under our current dividend payment practices, we may not retain a sufficient amount of cash and may need to seek financing to fund a material expansion of our business, including any significant acquisitions or to pursue growth opportunities requiring capital expenditures significantly beyond our current expectations.
Anti-takeover provisions in our charter documents, our shareholder rights plan and Minnesota law could prevent or delay a change in control of our Company. Provisions of our articles of incorporation and bylaws, our shareholder rights plan (also known as a poison pill) and Minnesota law may discourage, delay or prevent a merger or acquisition that a shareholder may consider favorable and may limit the market price for our common stock. These provisions include the following:
· Advance notice requirements for shareholders proposals,
· Authorization for our Board of Directors to issue preferred stock without shareholder approval; and
· Limitations on business combinations with interested shareholders.
Some of these provisions may discourage a future acquisition even though our shareholders would receive an attractive value for their shares or a significant number of our shareholders believe such a proposed transaction would be in their best interest.
Our stock price is volatile. Based on the trading history of our common stock and the nature of the market for publicly traded securities of companies in our industry, we believe that some factors have caused and are likely to continue to cause the market price of our common stock to fluctuate substantially. These fluctuations could occur day-to-day or over a longer period of time and may be accentuated by the lack of liquidity in our stock. The factors that may cause such fluctuations include, without limitation:
· General economic conditions in the United States or internationally,
· The financial health of HickoryTech, our competitors or our customers,
· Developments in telecommunications regulations,
· Consolidation among our competitors or customers,
· Rumors or speculation regarding HickoryTechs future business results and actions,
· Increased competition with our competitors or among our customers,
· Quarterly fluctuations in our financial results or the financial results of our competitors or customers,
· Announcements of new products and services by us or our competitors, and
· Disputes concerning intellectual property rights.
In addition, stocks of companies in our industry in the past have experienced significant price and volume fluctuations that are often unrelated to the operating performance of such companies. This market volatility may adversely affect the market price of our common stock.
There are no written comments that were received from the Securities and Exchange Commission staff 180 days or more before the end of our fiscal year relating to our periodic or current reports under the Securities Exchange Act of 1934.
Our business is primarily focused on the provision of service and our properties are used for administrative support and to store and safeguard equipment. On December 31, 2007, HickoryTechs gross property, plant and equipment of $322,249,000 (net balance of $152,931,000) consisted primarily of telephone switches, cable, fiber optic networks and network equipment. We own or lease the telephone property, plant and equipment that are utilized to operate our telephone systems. Our three ILEC subsidiaries in Minnesota and Iowa own central telephone offices with related real estate in all of the communities they serve. Our Telecom Sector owns the telephone network, including telephone outside plant, fiber optic cable and central office equipment over which they provide services to its customers. Our Enventis Sector owns, or has indefeasible rights to use, or has long-term leasing commitments to its extensive fiber optic network and switching system. It is our opinion that our properties are suitable and adequate to provide modern and effective telecommunications services within our service areas, including local dial-tone, long distance service, DSL, digital TV and dedicated and switched long-haul transport.
Our principal property locations are the following;
1. MCTCs general offices and principal central office exchange building located in downtown Mankato, Minnesota. This facility, built in 1963, is owned by MCTC and is a three-level brick and stone building containing approximately 60,000 square feet of floor space.
2. MCTCs main warehouse located in Mankato, Minnesota. This warehouse, built in 1996, is owned by MCTC and is a two-story concrete building containing approximately 48,000 square feet. The warehouse is used to store vehicles and supplies and is also used as office space for engineers and technicians.
3. Heartlands main central office equipment located in a one-story brick structure owned by Heartland in Rock Rapids, Iowa containing approximately 1,500 square feet of space. Heartland also leases approximately 2,000 square feet of general office space in Rock Valley, Iowa.
4. Crystal leases office space of approximately 6,000 square feet in Urbandale, Iowa.
5. NIBI owns a four-level building in Mankato, Minnesota containing approximately 17,000 square feet.
6. Enventis leases approximately 16,000 square feet of office space in Plymouth, Minnesota for general offices, technology services and system support.
7. Enventis leases approximately 7,500 square feet in Duluth, Minnesota for general offices and a network operations center.
8. Enventis leases approximately 1,700 square feet in Rochester, Minnesota for general offices and a network equipment facility.
9. Enventis licenses approximately 2,000 square feet in Edina, Minnesota for a data center.
Other than routine litigation incidental to our business, including the items listed below, there are no pending material legal proceedings to which we are a party or to which any of our property is subject.
HickoryTech is investigating a potential civil dispute being discussed with a municipality regarding contract payments from HickoryTech to the municipality in support of the Companys CLEC voice and data services. No formal dispute or claim has been filed to-date.
HickoryTech has received notice from a large interexchange carrier that they are disputing approximately $654,000 of interstate and intrastate switched access charges that HickoryTech billed them between October 2005 and October 2007. HickoryTech does not agree with this dispute and cannot predict the outcome of such proceedings nor their impact, if any, on the Company.
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this 2007 Annual Report on Form 10-K.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is quoted on the NASDAQ Global Select Market under the symbol HTCO. As of February 15, 2008, there were 1,430 registered shareholders and 1,778 beneficial owners of HickoryTech stock. HickoryTech has declared quarterly dividends on its common stock of $0.12 per share for the two years ended December 31, 2007 and 2006. A quarterly cash dividend of $0.12 per share will be paid on March 5, 2008 to stockholders of record at the close of business on February 15, 2008.
Dividend Tendencies and Restrictions
Our board of directors have adopted dividend payment practices that reflect its judgment that our stockholders would be better served if we distributed to them a portion of the cash generated by our business in excess of our expected cash needs rather than retaining it or using the cash for other purposes, such as to make investments in our business, or to make acquisitions. We expect to continue to pay quarterly dividends at an annual rate of $0.48 per share during 2008, but only if and to the extent declared by our board of directors on a quarterly basis and subject to various restrictions on our ability to do so (see below). Dividends on our common stock are not cumulative.
The terms of our credit facility include certain restrictions regarding the payment of dividends. The dividend restriction provides that we will not make dividend distributions or repurchase stock in an aggregate amount in excess of 100% of the previous years net income. In 2007, we were in violation of this dividend restriction, but a waiver was obtained.
The cash requirements of our current dividend payment practices are in addition to our other expected cash needs, both of which we expect to be funded with cash flow from operations. In addition, we expect we will have sufficient availability under our revolving credit facility to fund dividend payments in addition to any expected fluctuations in working capital and other cash needs, although we do not intend to borrow under this facility to pay dividends.
Five Year Shareholder Return Performance Presentation
The following table compares the cumulative total shareholder return on the common stock of HickoryTech for the last five fiscal years with the cumulative total return on the Russell 2000 Index and the NASDAQ Telecommunications Index. Total shareholder return assumes the investment of $100 in HickoryTechs common stock, the Russell 2000 index and the NASDAQ Telecommunication Index on December 31, 2002 and reinvestment of all dividends.
Total Return to Shareholders (Includes reinvestment of dividends)
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Hickory Tech Corporation, The Russell 2000 Index
And The NASDAQ Telecommunications Index
* $100 invested on 12/31/02 in stock or index-including reinvestment of dividends.
Fiscal year ending December 31.
(Dollars in thousands except share and per share amounts)
(A). Revenue and total assets for all periods have been restated to exclude revenue and assets of the wireless and Enterprise Solutions operations, which are included in discontinued operations for all periods presented. We sold our wireless operations in December 2003 and sold our Enterprise Solutions Sector in December 2006.
Critical Accounting Policies and Estimates
Managements discussion and analysis of financial condition and results of operations stated in this 2007 Annual Report on Form 10-K are based upon HickoryTechs consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States and, where applicable, conform to the accounting principles as prescribed by federal and state telephone utility regulatory authorities. HickoryTech presently gives accounting recognition to the actions of regulators where appropriate, as prescribed by Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation (SFAS No. 71). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Management believes that the application of the accounting policies, which are important to HickoryTechs financial position and results of operations, requires significant judgments and estimates on the part of management. Senior management has discussed the development and selection of accounting estimates and the related Management Discussion and Analysis disclosure with the Audit Committee. For a summary of all HickoryTechs accounting policies, see Note 1 to the Notes to the Consolidated Financial Statements. There were no significant changes to these accounting policies during the year ended December 31, 2007 except for the adoption of new policies to comply with adopting Financial Interpretation Number 48, Accounting for Uncertainty in Income Taxes an interpretation of Financial Accounting Standards Board (FASB) No. 109 (FIN No. 48).
We recognize revenue when (i) persuasive evidence of an arrangement between the customer and us exists, (ii) delivery of the product to the customer has occurred or service has been provided to the customer, (iii) the price to the customer is fixed or determinable and (iv) collectibility is reasonably assured.
Telecom Sector Revenue Recognition: Revenue in the ILEC and CLEC companies is earned from monthly billings to customers for telephone services, long distance, digital TV, DSL, Internet services, and hardware and other services. ILEC and CLEC revenue is also derived from charges for network access to our local exchange telephone network from subscriber line charges and from contractual arrangements for services such as billing and collection and directory advertising. Some revenue is realized under pooling arrangements with other telephone companies and is divided among the companies based on respective costs and investments to provide the services. The companies that take part in pooling arrangements may adjust their costs and investments for a period of two years, which causes the dollars distributed by the pool to be adjusted retroactively. We believe that recorded amounts represent reasonable estimates of the final distribution from these pools. However, to the extent that the companies participating in these pools make adjustments, there will be corresponding adjustments to our recorded revenue in future periods. Revenue is recognized in the period in which service is provided to the customer. With multiple billing cycles and cut-off dates, we accrue for revenue earned but not yet billed at the end of a quarter. We also defer services billed in advance and recognize them as income when earned based on billing dates.
Enventis Sector Revenue Recognition: Revenue in the Enventis Sector is generated from the following primary sources: i) the distribution of voice and data communications equipment provided primarily from Cisco, ii) providing design, configuration and installation services related to voice and data equipment, iii) the provision of Cisco maintenance support contracts, iv) the sale of professional support services related to customer voice and data systems, v) the sale of transport services over the Company-owned and leased fiber optic network, and vi) the sale of managed voice and data services, including resale of long distance services. Our revenue recognition policy for each of these types of products and services is as follows:
· In instances where Enventis sells Cisco voice and data communications equipment with no installation obligations (equipment only sales), all warranty obligations reside with Cisco. Therefore, revenue is recognized when the equipment is delivered to the customer site. In instances where Enventis sells Cisco voice and data communications equipment with installation obligations, terms of the agreements typically provide for installation services without customer-specific acceptance provisions, but sometimes may provide customer-specific acceptance provisions. For arrangements with no customer-specific acceptance arrangements, we recognize revenue when title passes to the customer. For contracts with customer specific acceptance provisions, we defer revenue recognition until the receipt of formal customer acceptance, assuming that all other revenue recognition criteria have been met. When a sale involves multiple elements, revenue is allocated to each respective element in accordance with Emerging Issues Task Force No. 00-21, Accounting For Revenue Arrangements with Multiple Deliveries (EITF No. 00-21), which addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. EITF No. 00-21 provides guidance on how an arrangement involving multiple deliverables should be divided into separate units of accounting, but does not change otherwise applicable revenue recognition criteria. In the event that we enter into a multiple element arrangement and there are undeliverable elements as of the balance sheet date, we assess whether the elements are separable and have determinable fair values in assessing the amount of revenue to record. Allocation of revenue to elements of the arrangement is based on fair value of the element being sold on a stand-alone basis.
· When we sell equipment to customers, we also typically sell Cisco support contracts (SmartNet contracts). These support contracts state that Cisco will provide all support services, product warranty and updates directly to the customer. Because Enventis has no service obligations under these types of contracts, the earnings process has culminated for us upon the sale of the contract and therefore revenue is recognized immediately. Further, we are serving in an agency relationship to the customer for the sale of the contract and therefore the revenue is recorded net of the cost that we pay Cisco for the contract. Support services also include Enventis offered 24X7 support of a customers voice and data systems. Most of these contracts are billed on a time and materials basis and revenue is recognized either as services are provided or over the term of the contract. Support services also include Enventis sponsored professional support services. Such services are typically sold on a time and materials basis, but may be sold as a pre-paid block of time. This revenue is recognized as the services are provided (deferred and recognized as utilized if pre-paid). In the event that these services are part of a multiple element arrangement, the fair value of the services are measured and deferred in accordance with EITF No. 00-21 mentioned above. Allocation of revenue to elements of the arrangement is based on fair value of the element being sold on a stand-alone basis.
· Transport services are sold primarily through a contractual flat monthly fee. The revenue generated by these services is typically billed one month in advance and is deferred until the appropriate month of recognition.
· Enventis also manages customer voice and/or data services. Under these contracts, Enventis bills either a flat monthly fee or a fee that is variable based on the number of seats that the customer has. This revenue is recognized on a monthly basis as the services are provided.
Allowance for Doubtful Accounts
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. In making the determination of the appropriate allowance for doubtful accounts, we consider specific accounts, historical write-offs, changes in customer relationships and credit worthiness and concentrations of credit risk. Specific accounts receivable are written off once a determination is made that the account is uncollectible. Additional allowances may be required if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments. The allowance for doubtful accounts was $1,184,000 and $851,000 as of December 31, 2007 and 2006, respectively.
Inventories are valued using the lower of cost (perpetual weighted average-cost or specific identification) or market method. Similar to its allowance for doubtful accounts, we make estimates related to the valuation of inventory. We adjust our inventory carrying value for estimated obsolescence or unmarketable inventory to the estimated market value based upon assumptions about future demand and market conditions. As market and other conditions change, additional inventory reserves may be established at a time when the facts that give rise to the lower value are warranted.
Financial Derivative Instruments
We use financial derivative instruments to manage our overall exposure to fluctuations in interest rates. We account for derivative instruments in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133), as amended by SFAS No. 149, Amendment of Statement 133 Accounting for Derivative Instruments and Hedging Activities (SFAS No. 149), which requires derivative instruments to be recorded on the balance sheet at fair value. Changes in fair value of derivative instruments must be recognized in earnings unless specific hedge accounting criteria are met, in which case the gains and losses are included in other comprehensive income rather than in earnings.
We utilize interest-rate swap agreements that qualify as cash-flow hedges to manage our exposure to interest rate fluctuations on a portion of our variable-interest rate debt. The market value of the cumulative gain or (loss) on financial derivative instruments is reported as a component of accumulated other comprehensive income (loss) in shareholders equity and is recognized in earnings over the term of the swap agreement. In March 2007, we terminated two outstanding interest-rate swap agreements with original maturities of June 2008 in exchange for $1,936,000 in proceeds. Proceeds of $1,272,000 were recognized as an offset to interest expense during 2007.
We amortize our definite-lived intangible assets over their estimated useful lives. Customer lists and other intangibles are amortized from one to eight years. Intangible assets with finite lives are amortized over their respective estimated useful lives to their estimated residual values. Identifiable intangible assets that are subject to amortization are evaluated for impairment.
Goodwill assets are not amortized, but are subject to an impairment test annually as well as upon certain events that indicate that impairment may be present. The goodwill impairment test requires management to determine the fair value of several of our reporting units (as defined by SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142)). We determine the fair value of our reporting units by application of a discounted cash flow analysis. Management makes estimates that are included in its discounted cash flow analysis based upon the best available information at the time that the determinations of fair value are made. If circumstances change, our estimates of fair value will also change and could result in a determination of additional impairment charges to reduce the carrying value of goodwill.
We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (SFAS No. 109), as clarified by FIN No. 48. Under this method deferred income taxes are based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of enacted tax laws. Deferred income tax provisions and benefits are based on changes to the assets or liabilities from year to year. In providing for deferred taxes we consider tax regulations of the jurisdictions in which we operate, estimates of future taxable income, and available tax planning strategies. If tax regulations, operating results, or the ability to implement tax-planning strategies vary from our assumptions, we may be required to adjust the carrying value of deferred tax assets and liabilities. Valuation allowances are recorded related to deferred tax assets based on the more likely than not criteria of SFAS No. 109.
FIN No. 48 requires us to recognize the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. See additional disclosures regarding application of FIN No. 48 in Note 11 to the Notes to the Consolidated Financial Statements.
As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. This process involves estimating the current tax exposure together with assessing temporary differences resulting from the differing treatments of items such as deferred revenue for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We assess the likelihood that deferred tax assets will be recovered from future taxable income and to the extent recovery is not likely, it establishes a valuation allowance. To the extent that we establish a valuation allowance or increase this allowance in a period, it must be included as an expense within the tax provision in the statement of operations. We had a valuation allowance of $1,550,000 and $1,616,000 at December 31, 2007 and 2006, respectively, due to uncertainty about the realization of benefits associated with net operating losses generated in the state of Iowa. In addition, the Company carries reserves for income tax contingencies. These reserves relate to various tax years subject to audit by tax authorities. We believe our current income tax reserves are adequate. However, the ultimate outcome may differ from estimates, and assumptions could impact the provision for income taxes reflected in the consolidated statements of operations.
The net post-retirement benefit expense was $859,000, $924,000 and $1,051,000 in 2007, 2006 and 2005, respectively. Post-retirement benefit expense is recorded in cost of services and selling, general and administrative expenses. The post-retirement benefit expense and liability are calculated utilizing various actuarial assumptions and methodologies. These assumptions include, but are not limited to, the discount rate and the expected health care cost trend rate.
Post-retirement benefits were calculated in accordance with the methods specified in SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB statements No. 87, 88, 106 and 132(R) (SFAS No. 158), and SFAS No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions (SFAS No. 106). Where SFAS No. 106 provides alternative methods for determining net periodic benefit costs, we adopted the following policies: Any prior service cost or cumulative net gains and losses in excess of 10% of the SFAS No. 106 corridor, are amortized on a straight-line basis over the average future service lives of the covered group. There are no substantive commitments for benefits other than as stated in the written plan. According to the guidance of paragraph 186 of SFAS No. 106, the objective of selecting assumed discount rates is to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments, would provide the necessary future cash flows to pay the accumulated benefits when due. The assumed discount rate represents the discounted value of necessary future cash flows required to pay the accumulated benefits when due. The rate was determined based on available market data regarding the spot rate yields in half year increments on high-quality fixed income securities with the effects of puts and calls removed that provide cash flows at the same time and in the same amount as the projected cash flows of the plan.
In measuring the accumulated post-retirement benefit obligation as of December 31, 2007, we assumed a weighted average discount rate of 6.20%. The reduction in the discount rate by 25 basis points would increase the accumulated post-retirement benefit obligation by approximately $310,000 as of December 31, 2007 and would increase the net periodic cost by approximately $36,000 as of December 31, 2007.
The health care cost trend rate is based upon an evaluation of the historical trends and experience, taking into account current and expected market conditions. The health care cost trend rate represents the expected annual rate of change in the cost of health care benefits currently provided due to factors other than changes in the demographics of plan participants. If the assumptions utilized in determining the post-retirement benefit expense and liability differ from actual events, the results of operations for future periods could be impacted.
In measuring the accumulated post-retirement benefit obligation as of December 31, 2007, the initial health care inflation rate for 2008 was assumed to be 8.0%, decreasing 0.5% each year until it reaches 4.5% in 2015 and remains at 4.5% for the years thereafter. These assumptions were provided based on a study of the ten-year history of our self-funded medical benefits plan. This has resulted in HickoryTech consistently having lower increases in health care costs than the national averages. A one-percentage point increase in the health care inflation rate for each year would increase the accumulated post-retirement benefit obligation by $1,269,000. A one-percentage point decrease in the health care inflation rate for each year would decrease the accumulated post-retirement benefit obligation by $1,023,000.
When actual events differ from the assumptions or when the assumptions used change, an unrecognized actuarial gain or loss results. As of December 31, 2007, the unrecognized net actuarial loss was $1,583,000. During each of the last three years, we adjusted the discount rate assumption due to changes in interest rates. In recent years, we adjusted the health care cost trend rate assumption to reflect the current trend of medical costs. The remainder of the net actuarial loss amount primarily related to differences between the assumed medical costs and actual experience and changes in the employee population. The recognized net actuarial loss outside the allowable corridor is expected to be recognized over the next 12.2 years. This amount will change in future years as economic and market conditions generate gains and losses.
Property, Plant and Equipment
Property, plant and equipment are recorded at original cost of acquisition or construction. When regulated ILEC telephone assets are sold or retired, the assets and related accumulated depreciation are removed from the accounts and any gains or losses on disposition are amortized with the remaining net investment in telephone plant. When other plant and equipment is sold or retired, the cost and related accumulated depreciation or amortization are removed from the respective accounts and any resulting gain or loss is included in operating income. Maintenance and repairs are charged to expense as incurred.
On December 30, 2005 we acquired Enventis. The Enventis property, plant and equipment, consisting primarily of a fiber optic communications network was valued under SFAS No. 141, Business Combinations (SFAS No. 141), as it pertains to accounting for assets under Purchase Accounting. We recorded the assets at fair value at the time of acquisition. Also included in the Enventis property, plant and equipment is fiber optic cable and indefeasible right of use of fiber installed by others accompanied by ownership rights. Both of these categories of assets have depreciable lives of 16 to 20 years on the assets acquired on December 30, 2005 and 25 years for new additions.
Depreciation for financial statement purposes is determined using the straight-line method based on the lives of the various classes of depreciable assets. The composite depreciation rates on the ILEC telephone plant were 4.8%, 4.9% and 5.4% for 2007, 2006 and 2005, respectively. All other property, plant and equipment are depreciated over estimated useful lives of 3 to 20 years.
The Telecom Sector leases certain computer equipment under capital lease arrangements. We have recorded the present value or fair value of the future minimum lease payments as a capitalized asset and related lease obligation. Assets under these capital leases are included in property, plant and equipment.
We recognize stock compensation charges related to stock award plans when management concludes it is probable that the participant will earn the award. Such compensation charges are recorded based upon the fair value of our stock and is recognized during the service period specified by the stock award plan. Changes in estimated compensation are recorded in the period in which the change occurs.
On January 1, 2006, we adopted SFAS No. 123(R) (revised 2004), Share Based Payment (SFAS No. 123(R)), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to the employee stock purchase plan, based on estimated fair values. SFAS No. 123(R) supersedes our previous accounting under Accounting Principles Board No. 25, Accounting for Stock Issued to Employees (APB No. 25), for periods beginning in 2006. In March 2005, the FASB issued Staff Accounting Bulletin No. 107, Share-Based Payment (SAB No. 107), which relates to SFAS No. 123(R). We have applied the provisions of SAB No. 107 in its adoption of SFAS No. 123(R). We adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006.
Our Consolidated Financial Statements for 2006 reflect the impact of SFAS No. 123(R). In accordance with the modified prospective transition method, the Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R) or any modifications to outstanding stock options prior to the adoption of SFAS No. 123(R). The adoption of SFAS No. 123(R) had minimal impact on earnings per share, diluted earnings per share and cash flow from financing and operations in 2006 and 2007.
Share-based compensation expense recognized during a period is based on the value of the portion of share-based payment awards that are ultimately expected to vest during the period. Share-based compensation expense recognized in the Consolidated Statements of Operations includes compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the fair value provisions of SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), as well as grants in 2006 under SFAS No. 123(R). Because share-based compensation expense recognized in the Consolidated Statements of Operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. We use historical data to estimate pre-vesting forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. We use a seven-year period to calculate the historical volatility of its stock price for use in the valuation model. The dividend yield rate is based on our current dividend payout pattern and current market price. The risk-free rate for options is based on a U.S. Treasury rate commensurate with the expected terms. The expected term of options granted is derived from historical experience and represents the period of time that options granted are expected to be outstanding.
HickoryTech is a holding company with a diverse business of traditional wireline local exchange telecommunications, state-of-the-art broadband services in the retail communications field including high-speed data and digital TV service serving dominant market shares of residential and business customers in specific cities in Minnesota and Iowa. We also provide fiber network capacity and integrated Internet protocol telephony and data services to an exclusively commercial business market. From the base incumbent telephone companies, we began to expand our business beyond our ILEC business in 1998 via a CLEC edge-out strategy. We chose to serve entire communities, residential and business, in communities in proximity to our ILEC service area, on a total overbuild basis, meaning we use our own network and switching assets. We began an aggressive broadband service campaign with DSL in 1999, deployed residential digital TV service in 2001 and added business high speed data applications (Ethernet) in 2004. In December, 2005, our acquisition of Enventis enhanced a business-to-business service strength, adding to that which was already in place at HickoryTech. Enventis revenue was approximately $50,000,000 prior to the acquisition. Through Enventis, we serve wholesale communications carriers with fiber network connectivity in several states and provide integrated dedicated voice and data circuits, Internet protocol telephony and data services to large/enterprise and the small/medium size retail business customers.
We operate in two business segments: the Telecom and Enventis Sectors. Our largest and oldest product and service line (since 1898) has been the operation of ILECs or traditional wireline telephone service. The ILEC product and service line resides in our Telecom Sector. In 1998, we formed a CLEC and started offering services on a competitive basis in several market areas. This product and service line competes for the telephone dial tone, Internet dial-up and broadband access, data, digital TV and long distance calling business in ILEC territories owned by HickoryTech and others. We account for our CLEC product and service line in our Telecom Sector. Since 1964, NIBI has provided computer data processing and software, predominantly for our Telecom Sector operations and also to other telecommunications companies. Both ILEC and CLEC operations are managed as one coordinated unit. From 1990 to 2006, HickoryTech also owned Collins Communications Systems Company (Collins), and its results of operations were reported in the Enterprise Solutions Sector. We acquired Collins in 1990 and it operated as a telecommunications, data and Internet protocol equipment distributor from a base in Minneapolis/St. Paul, Minnesota. We sold our Collins operations on December 29, 2006. All financial statements and schedules have been restated to reflect Collins operations as discontinued operations for all periods presented. We purchased Enventis, a Minnesota-based regional provider of integrated fiber network, Internet protocol telephony and data services with 1,500 route miles of fiber network serving business customers in the Upper Midwest in December 2005.
Our operations in the Telecom Sector consist primarily of providing services to their customers for a fee. Many of these services are recurring, and, as a result, backlog orders and seasonality are not significant factors. Working capital requirements for the Telecom Sector include the financing of construction of networks, which consists of switches and cable, data, Internet protocol and digital TV. Capital is also needed to maintain a high amount of fixed assets, for software development, to pay payroll costs of highly skilled labor, to maintain inventory to service capital projects and network and telephone equipment customers, and providing for the carrying value of trade accounts receivable, which may take several months to collect in the normal course of business.
A significant portion of the business conducted in our Enventis Sector consists of equipment sales and thus, has a higher degree of cyclical highs and lows due to its non-recurring/sales order nature of business. Working capital requirements for the Enventis Sector include the construction of fiber/optical equipment, Internet protocol equipment, capital for payroll costs, work-in-process and inventory. Enventis working capital is also required for the carrying value of trade accounts receivable, particularly in the equipment revenue product line, where receivables may take several months to collect in the normal course of business.
The materials and supplies that are necessary for the operation of the businesses are available from a variety of sources. Our Telecom Sector currently relies on one vendor to supply a key piece of equipment in its digital TV product line. We are currently working with other vendors to potentially supply this equipment. All of our central office switches are supplied by Nortel. A majority of the equipment sold in our Enventis Sector is supplied by Cisco. Nortel and Cisco are leading suppliers of communications and data equipment, and our dependence on these brands is not viewed as a significant risk.
Highlights of 2007
As of December 31, 2007, Enventis completed its second year as a wholly owned subsidiary. Enventis Sector revenue for 2007 represented a 37.6% increase over revenue for 2006 and Enventis Sector net income increased 198.9% over that same time period. We believe the Enventis Sector will continue to provide long-term growth for the Company, but not necessarily at the levels achieved in 2007.
The operations of our legacy Telecom business again reached new milestones of DSL and digital TV penetration in 2007. Digital TV services were initiated in the communities of Janesville, North Mankato and on a limited basis, in Mankato. The Telecom business experienced increased competition in 2007 as cable TV providers launched voice services. The Telecom Sector has also continued to experience price erosion in its core voice business.
2007 Compared to 2006
· Consolidated operating revenue in 2007 was $156,649,000, a $23,748,000 or 17.9% increase compared to 2006. This increase was primarily due an $18,565,000 increase in revenue from the Enventis Enterprise Network Services product line in 2007 compared to 2006. Also contributing to the increase in revenue in 2007 compared to 2006 was an increase of $3,232,000 in the Enventis Enterprise Transport Services product line. The Telecom Sector experienced non-recurring revenue of $1,890,000 due to the settlement of a switched access revenue dispute.
· Cost of sales (excluding Depreciation and Amortization) in 2007 was $45,340,000, a $14,188,000 or 45.5% increase compared to 2006. The increase in 2007 compared to 2006 was primarily due to the costs incurred to support the increased revenue in the Enventis Enterprise Network Services product line. These costs are primarily equipment material costs. Labor associated with installation work is not included in this category, but is included in cost of services (excluding depreciation and amortization) described below.
· Cost of services (excluding Depreciation and Amortization) was $44,881,000 in 2007, a $375,000 or 0.8% increase compared to 2006. This increase was primarily due to the increase in Enventis Sector cost of services, offset by the decrease in the Telecom Sector cost of services. See the individual Sector results of operations for the Telecom Sector and Enventis Sector for an explanation of the changes in each individual Sector.
· Selling, General and Administrative Expenses were $24,244,000 in 2007, a $953,000 or 4.1% increase compared to 2006. The Enventis Sector recorded acquisition integration costs of approximately $2,400,000 in 2006 which did not recur in 2007. Without these one-time costs, our selling, general and administrative expenses would have increased 16.0% in 2007 compared to 2006. This substantial increase in costs was used to support the higher activity levels of the Enventis Sector operations in 2007.
· Depreciation Expense was $17,847,000 in 2007, an $898,000 or 5.3% increase compared to 2006. This increase was primarily due to the $707,000 increase in Enventis Sector depreciation, which was the result of an increase in assets placed in service in 2006 and 2007.
· Amortization Expense was $1,157,000 in 2007, a $15,000 or 1.3% decrease compared to 2006.
2006 Compared to 2005
· Consolidated revenue was $132,901,000 in 2006, a $54,979,000 or 70.6% increase compared to 2005. This increase was due to revenue recognized from the addition of Enventis. Without Enventis, consolidated revenue would have decreased by 3.9%.
· Cost of sales (excluding Depreciation and Amortization) was $31,152,000 in 2006 with none in 2005. The cost of sales was directly associated with the new Enventis revenue recognized in 2006.
· Cost of services (excluding Depreciation and Amortization) was $44,506,000 in 2006, a $13,098,000 or 41.7% increase compared to 2005. This increase was primarily due to costs associated with the new Enventis operations. Without Enventis, cost of services would have increased 1.5%.
· Selling, General and Administrative Expenses were $23,291,000 in 2006, a $10,691,000 or 84.8% increase compared to 2005. This increase was primarily due to costs associated with the new Enventis operations. Without Enventis, selling, general and administrative expenses would have increased 13.6%. In addition to the ongoing costs of Enventis selling, general and administrative activities, Enventis incurred approximately $2,400,000 of integration costs in 2006, which did not reoccur.
· Depreciation Expense was $16,949,000 in 2006, a $2,006,000 or 13.4% increase compared to 2005. This increase was essentially all due to depreciation associated with the new Enventis assets.
· Amortization Expense was $1,172,000 in 2006, a $679,000 or 137.7% increase compared to 2005. This increase was essentially all due to amortization associated with the new Enventis intangibles.
Our consolidated revenue increased 17.9% and our income from continuing operations increased 65.0% in 2007 compared to 2006. These substantial improvements in the results of operations were a function of improvements in both the Telecom and Enventis Sectors. Enventis Sector revenue increased 37.6% in 2007 compared to 2006 and net income almost tripled in that same time period. The Enventis Sector recorded acquisition integration costs of approximately $2,400,000 in 2006, which did not reoccur in 2007. The combination of a $1,890,000 non-recurring recovery of a switched access dispute with a large interexchange carrier in 2007, as well as expense reductions, enabled the Telecom Sector to post a 17.9% increase in operating income in 2007 compared to 2006. Without these two non-recurring events (the interexchange carrier settlement and the elimination of integration costs), our consolidated income from continuing operations would have increased by $826,000 or 12.3% in 2007 compared to 2006.
Longer term, we expect local service and network access revenue in our Telecom Sector to continue to trend downward because of competition from CLECs, cable TV providers, voice over Internet protocol, wireless telephone, other telephone competitors and due to reduced usage and pricing of network access service. This competition will affect basic customer connections and choices made by specific customers not to interconnect or utilize the Companys network or services. We were successful in 2007 in completely offsetting this declining revenue with increased revenue from broadband services. Without the one-time settlement of a switched access dispute with a large interexchange carrier mentioned above, network access revenue would have decreased by $934,000 or 3.1% in 2007 compared to 2006. Network access revenue and Telecom Sector margins were both negatively impacted by a reduction in interstate network access rates that went into effect on July 1, 2007 as well as by the competitive voice services that were offered by the cable TV providers in Northwest, Iowa in the first quarter of 2007 and in Mankato, our largest market, in the third quarter of 2007. The entire decline in network access revenue (before the settlement of the switched access dispute) occurred in the third and fourth quarters of 2007, thus establishing a new trend. Accordingly, while we will continue to work to offset declining revenue with new services to our customers in the Telecom Sector, the trend toward decreasing profitability in this Sector may resume.
We believe our Enventis Sector provides a platform for longer-term growth. Enventis revenue for 2007 represented a 37.6% increase over 2006 revenue. Enventis provided profitable operations and recorded positive operating income in each of the eight quarters since its acquisition. Enventis consists of two major product lines. Our equipment sales and service product line - Enterprise Network Services - is subject to cyclical highs and lows depending on customer demand. The Enterprise Transport Services product line provides network-based service for wholesale and retail use by customers. This product line contains more of a recurring revenue stream and is supported by long-term contracts. Both the Enterprise Network Services and Enterprise Transport Services product lines have shown excellent growth characteristics. One of our strategies is to sell bundled Enterprise Network Services to customers with the goal that they will also utilize our Enterprise Transport Services as well.
Due to increased profitability in both the Enventis and Telecom Sectors in 2007, we were able to reduce our outstanding debt balance in 2007 compared to 2006. Despite the decrease in the debt balance, interest expense increased due to lower cooperative dividends received in 2007 from one of our participating lenders, the expiration of a swap agreement and the re-setting of the rate on a remaining swap agreement. Cooperative dividends are accounted for as an offset to interest expense when earned. In addition, the effective interest rate on our debt was also higher in 2007 than in 2006 due to the establishment of longer-term interest protection.
Income from continuing operations increased to $8,635,000 in 2007 from $5,235,000 in 2006, due to the improved profitability in both the Enventis and Telecom Sectors, offset by the increase in interest expense.
Sector Results of Operations
The following table provides a breakdown of the Telecom Sector operating results.
(1) DSL line counts were reduced by 478 in 2007 due to a data conversion. There was no restatement of prior periods.
Telecom Sector operating revenue before intersegment eliminations was $2,158,000 or 2.9% higher in 2007 compared to 2006, and $2,894,000 or 3.7% lower in 2006 compared to 2005. The increase in 2007 compared to 2006 was primarily due to increases in network access, data and digital TV, offset by a decrease in local service. Without the non-recurring settlement of a switched access dispute with a large interexchange carrier (see below), which increased revenue by $1,890,000 in 2007, revenue would have increased $268,000 or 0.4% in 2007 compared to 2006, primarily due to our success in growing broadband services. The decrease in 2006 compared to 2005 was primarily due to decreases in network access, other revenue, and message processing and billing, partially offset by growth in data and digital TV.
Local service revenue was $1,135,000 or 6.2% lower in 2007 compared to 2006. This decrease was primarily due to a 3,212 or 4.7% decrease in access lines at December 31, 2007 compared to December 31, 2006. Also contributing to the decrease in local service revenue was a decline in reciprocal compensation received from wireless carriers under contract using minute of use pricing. Many of these contracts and their associated pricing were renegotiated in the first nine months of 2007. A higher degree of competition from ILECs, CLECs and cable TV providers serving our markets and from wireless substitution, could impact our local service revenue in future periods. Local service revenue was $296,000 or 1.6% lower in 2006 compared to 2005. This decrease was primarily due to a 2,047 or 2.9% decrease in access lines at December 31, 2006 compared to December 31, 2005.
Network access revenue was $956,000 or 3.2% higher in 2007 compared to 2006. This increase was due to the settlement of a switched access dispute with a large interexchange carrier which resulted in a non-recurring increase in revenue of $1,890,000 in the second quarter of 2007 and was partially offset by lower revenue resulting from decreased minutes of use in 2007 compared to 2006 and lower interstate network access rates which went into effect on July 1, 2007. Without the impact of the non-recurring access settlement, network access revenue would have decreased by $934,000 or 3.1% in 2007. The combination of changing minutes of use, carriers optimizing their network costs and lower demand for dedicated lines may negatively impact future access revenue. In addition, future federal or state access reform may provide further negative influences. The public utilities commissions have been considering intrastate access reform and universal service for several years (see Regulation on pages 8 to 14). Network access revenue was $3,448,000 or 10.3% lower in 2006 compared to 2005. This decrease was primarily due to a mandated ILEC interstate rate decrease implemented on July 1, 2005, lower overall minutes of use and the recognition of the impact of different treatment of traffic delivered via Qwest Communications, all of which are expected to be lasting in nature.
Long distance revenue was $191,000 or 3.9% higher in 2007 compared to 2006. Despite a 240 or 0.6% decrease in the customer base at December 31, 2007 compared to December 31, 2006, long distance revenue increased largely due to a 7.6% increase in minutes of use in 2007 compared to 2006. Long distance revenue was $56,000 or 1.2% higher in 2006 compared to 2005. This increase was primarily due to an 875 or 2.2% increase in the customer base between December 31, 2006 and December 31, 2005, combined with higher long distance usage per customer.
Data revenue was $852,000 or 14.1% higher in 2007 compared to 2006. This increase was primarily due to a $561,000 increase in Ethernet services to large business customers and an increase in DSL customers of 1,703 or 10.8% between December 31, 2007 and December 31, 2006. We believe Ethernet service revenue will continue to provide growth opportunities for HickoryTech. Expanded networking opportunities among medium and large business customers are key drivers for this growth. Data revenue was $1,080,000 or 21.7% higher in 2006 compared to 2005. This increase was primarily due to increased broadband services to business customers, a 2,702 or 20.7% increase in DSL customers at December 31, 2006 compared to December 31, 2005 and DSL customers migrating from lower speed DSL products to higher speed DSL products, which have the effect of increasing revenue per customer.
Internet revenue was $145,000 or 3.2% higher in 2007 compared to 2006, and $106,000 or 2.4% higher in 2006 compared to 2005. The increase in both periods was primarily due to an increase in Internet customers.
Digital TV revenue was $816,000 or 56.0% higher in 2007 compared to 2006. This increase was primarily the result of the offering of digital TV to three additional communities in 2006 and three additional communities in 2007, which resulted in a 1,855 or 40.0% increase in digital TV customers at December 31, 2007 compared to December 31, 2006. Also contributing to the increase in digital TV revenue was an increase in rates charged to customers of approximately 5.0%, which went into effect in April 2007. Digital TV revenue was $478,000 or 48.8% higher in 2006 compared to 2005. This increase was primarily due to the expansion of digital TV in three additional communities in the latter half of 2005 and three additional communities in 2006, which resulted in a 1,866 or 67.5% increase in digital TV customers at December 31, 2006 compared to December 31, 2005.
Directory revenue was $230,000 or 6.3% higher in 2007 compared to 2006. This increase was the result of an increase in the sales of yellow-page advertising in the Company directories, which went into effect in the beginning of the third quarter of 2007. Directory revenue was $115,000 or 3.3% higher in 2006 compared to 2005. This increase was the result of increased advertising in the Company directories.
NIBI message processing revenue was $347,000 or 16.3% higher in 2007 compared to 2006. This increase was primarily due to the recognition of $259,000 of non-recurring license fee revenue in 2007 compared to 2006. Also contributing to the increase in revenue was the addition of several new customers offset by lower message counts to several other customers. NIBI message processing revenue was $395,000 or 15.7% lower in 2006 compared to 2005. This decrease was primarily due to the Company recognizing $396,000 in non-recurring license fees from the sale of SuiteSolution® to a customer in June 2005. The addition of several customers and increased volumes from existing customers, helped offset the loss of non-recurring license fee revenue.
Other revenue, consisting primarily of sales of customer premise equipment, circuit private lines, maintenance, and adds, moves and changes was $451,000 or 10.9% lower in 2007 compared to 2006. This decrease was primarily due to lower revenue of $767,000 associated with the SOCRATES contract whose service was discontinued in 2006, offset by an increase in Telecom back office contract services of $179,000 and an increase in customer premise equipment revenue of $171,000. Until June 2006, we had provided Internet access and video conferencing for Project SOCRATES which is a distance-learning network connecting schools and libraries in a 12-county region in south central Minnesota. Our contract with Project SOCRATES ended on June 30, 2006. Other revenue was $722,000 or 14.9% lower in 2006 compared to 2005. This decrease was primarily due to the loss of $670,000 associated with the SOCRATES contract mentioned above.
Cost of Services (excluding Depreciation and Amortization)
Telecom Sector cost of services (excluding depreciation and amortization) was $1,153,000 or 3.6% lower in 2007 compared to 2006. This decrease was primarily due to the following items: 1) a $733,000 decrease in professional and consulting fees due to lower fees associated with the conversion of our enterprise resource planning software and provisioning software, 2) a $444,000 decrease in contract labor largely due to the retirement of mainframe computer functions in the NIBI business in 2006, 3) a $416,000 decrease in charges to the inventory reserve, 4) a $233,000 decrease in circuit expenses and 5) a $193,000 decrease in bad debt expense largely associated with the settlement of a switched access dispute with a large interexchange carrier in 2007. These decreases were partially offset by the following items: 1) a $674,000 increase in programming expense to support the increase in digital TV services and 2) a $263,000 increase in incentive compensation payments in 2007.
Telecom Sector cost of services (excluding depreciation and amortization) was $638,000 or 2.0% higher in 2006 compared to 2005. This increase was primarily due to the following items 1) a $378,000 increase in programming expense associated with the increase in digital TV revenue, 2) a $325,000 increase in the inventory reserve, 3) a $299,000 increase in customer premise equipment and 4) a $170,000 increase in maintenance contracts. These increases were partially offset by the following items: 1) a $340,000 decrease in circuit expense associated with providing Internet services and 2) a $301,000 decrease in wages and benefits due to a reassignment of support staff for the NIBI product line to activities reported as selling, general and administrative expenses.
Selling, General and Administrative Expenses
Telecom Sector selling, general and administrative expenses were $406,000 or 3.1% higher in 2007 compared to 2006. This increase was primarily due to a $170,000 increase in corporate expense allocations, a $162,000 increase in incentive compensation expense in 2007 and a $159,000 increase in franchise fees associated with digital TV contracts with various cities. Telecom Sector selling, general and administrative expenses were $563,000 or 4.5% higher in 2006 compared to 2005. This increase was primarily due to a $730,000 increase in wages and benefits ($301,000 of this increase was due to the reassignment of wages from costs of services as mentioned above), partially offset by a $335,000 decrease in fees associated with the termination of leases in 2005 in the NIBI product line.
Depreciation and Amortization
Telecom Sector depreciation and amortization was $209,000 or 1.4% higher in 2007 compared to 2006, and $366,000 or 2.4% lower in 2006 compared to 2005. Telecom Sector depreciation was $223,000 or 1.5% higher in 2007 compared to 2006, and $6,000 or 0.1% higher in 2006 compared to 2005. The increase or decrease in depreciation in any given period is dependent on the net level of capital assets placed in service and retirements on a period by period basis. Telecom Sector amortization was $14,000 or 11.6% lower in 2007 compared to 2006, and $372,000 or 75.5% lower in 2006 compared to 2005. The decrease in amortization in 2006 compared to 2005 was primarily due to capitalized development costs in connection with the NIBI SuiteSolution® billing software becoming fully amortized in the second quarter of 2005.
Telecom Sector operating income was $2,696,000 or 17.9% higher in 2007 compared to 2006. This increase was due to the $2,158,000 increase in revenue (principally due to the interexchange carrier settlement of $1,890,000), the $1,153,000 decrease in cost of services (excluding depreciation and amortization) and the $14,000 decrease in amortization, offset by the $406,000 increase in selling, general and administrative expenses and the $223,000 increase in depreciation. Telecom Sector operating income was $3,729,000 or 19.8% lower in 2006 compared to 2005. This decrease was primarily due to the $2,894,000 decrease in revenue, the $638,000 increase in cost of services (excluding depreciation and amortization), the $563,000 increase in selling, general and administrative expenses, and the $6,000 increase in depreciation, offset by the $372,000 decrease in amortization.
Income from Continuing Operations, net of Tax
Telecom Sector income from continuing operations, net of tax, was $1,223,000 or 13.2% higher in 2007 compared to 2006. This increase was primarily due to increased operating income mentioned above, offset by the change in taxes. Telecom Sector income from continuing operations, net of tax, was $2,087,000 or 18.4% lower in 2006 compared to 2005. This decrease was primarily due to decreased operating income mentioned above and the change in taxes.
The following table provides a breakdown of the Enventis Sector operating results. Due to the timing of the acquisition of Enventis, no 2005 historical results are presented.
(1) Certain reclassifications of prior period data were made to conform to the current presentation on this Form 10-K. The reclassifications did not affect cash flows, financial postion, or net income.
HickoryTech Corporation acquired Enventis on December 30, 2005. We continue to manage and evaluate the Enventis operations in their entirety. The table below however, provides an illustration of the significant growth experienced in and relative contributions from each of the Enventis primary product lines. Certain allocations have been made, particularly in the area of Selling, General and Administrative Expenses, in order to develop these tables.
ENVENTIS PRODUCT LINE REPORTING
Enventis Sector operating revenue before intersegment eliminations was $22,187,000 or 38.2% higher in 2007 compared to 2006. This increase was primarily due to the increase in Enterprise Network Services equipment revenue (see below).
Enterprise Network Services equipment revenue was $14,855,000 or 41% higher in 2007 compared to 2006. This increase was primarily due to revenue recognized from a large equipment installation contract with a customer, which accounted for $14,290,000 in equipment revenue. Due to the one-time nature of equipment sales, the Enterprise Network Services equipment revenue growth from year-to-year is dependant on the addition of new customers to replace and exceed revenue received from existing customers.
Enterprise Network Services revenue (non-equipment) was $3,710,000 or 81% higher in 2007 compared to 2006. This increase was primarily due to a $1,880,000 increase in maintenance revenue, which was largely the result of an increase in maintenance recognized to one customer of $1,331,000 in 2007 compared to 2006. Also contributing to the increase in non-equipment revenue in 2007 compared to 2006 was a $1,858,000 increase in contract services revenue associated with an increase in design, configuration and installation services related to voice and data equipment.
Enterprise Transport Services revenue was $3,232,000 or 18.8% higher in 2007 compared to 2006. This increase was primarily due to a $3,406,000 increase in fiber transport services.
Cost of Sales Equipment (excluding Depreciation and Amortization)
Enventis Sector cost of sales (excluding depreciation and amortization) associated with equipment revenue increased $14,188,000 or 45.5% in 2007 compared to 2006. This increase was primarily due to the costs incurred to support the increased revenue in the Enterprise Network Services product line. These costs are primarily equipment material costs. Labor associated with installation work is not included in this category, but is included in cost of services (excluding depreciation and amortization) described below.
Cost of Services (excluding Depreciation and Amortization)
Enventis Sector cost of services (excluding depreciation and amortization) increased $2,126,000 or 16.8% in 2007 compared to 2006. This increase was primarily due to the following items: 1) a $1,179,000 increase in circuit expenses, which supported the increase in off-net revenue, 2) a $1,092,000 increase in wages and benefits due to increased staffing levels and 3) a $548,000 increase in professional fees due to external project management consulting. Offsetting the increase in cost of services was a $904,000 decrease in bad debt expense, which was the result of the collection of several previously written-off customer accounts and a lower amount of bad debt accruals in 2007.
Selling, General and Administrative Expenses
Enventis Sector selling, general and administrative expenses increased $502,000 or 5.6% in 2007 compared to 2006. This increase was primarily due to the following items: 1) a $656,000 increase in corporate expense allocations, 2) a $209,000 increase in computer expenses and a 3) $183,000 increase in professional accounting fees. Offsetting the increase was a $632,000 decrease in wages and commissions, which was the result of non-recurring bonus and overtime payments made in 2006.
The Enventis Sector recorded acquisition integration costs of approximately $2,400,000 in 2006, which did not reoccur in 2007. Without these one-time costs, Enventis Sector selling, general and administrative expenses would have increased 44.1% in 2007 compared to 2006. This substantial increase in costs was used to support the higher activity and operation levels of the Enventis Sector in 2007.
Depreciation and Amortization
Enventis Sector depreciation and amortization was $707,000 or 23.2% higher in 2007 compared to 2006. Enventis Sector depreciation was $707,000 or 35.4% higher in 2007 compared to 2006. This increase was primarily due to the increase in assets placed in service in 2006 and 2007. Enventis Sector amortization remained constant in 2007 and 2006, respectively, and is attributed to intangible assets related to the Enventis acquisition in 2005.
Enventis Sector operating income was $4,664,000 or 208.2% higher in 2007 compared to 2006. This increase was due to the $22,187,000 increase in operating revenue, offset by the $14,188,000 increase in cost of sales (excluding depreciation and amortization), the $2,126,000 increase in cost of services (excluding depreciation and amortization), the $707,000 increase in depreciation and the $502,000 increase in selling, general and administrative expenses.
Enventis Sector net income was $2,711,000 or 198.9% higher in 2007 compared to 2006. This increase was primarily due to the increased operating income mentioned above, offset by the change in taxes.
Discontinued Operations Enterprise Solutions Sector
Effective December 31, 2006, we sold Collins to Skyview Capital, LLC. The selling price was comprised of a $100,000 note and up to $1,650,000 of earn-out payments in exchange for all of the Collins outstanding capital stock. Skyview Capital, LLC paid us $100,000 in February 2007. The remaining selling price is due in contingent payments payable over the next four years based on financial targets reached by Skyview Capital, LLC. We have received no payments to-date related to this earn-out provision. The $100,000 mentioned above has been included in the calculation of the net loss mentioned below, while the contingent payments have not been included in the net loss. The agreement also contains a service agreement, whereby Skyview Capital, LLC agrees to provide customer support as a subcontractor for our Nortel equipment business. This agreement contains covenants against competition by the new owner in south-central Minnesota. HickoryTech recorded a pre-tax loss on the sale of $3,385,000 ($2,040,000 net of income taxes). The Collins results of operations were formerly reported in the Enterprise Solutions Sector. The consolidated statements of operations for all periods presented have been restated to reflect the Collins operations as discontinued operations (see Note 3 to the Notes to the Consolidated Financial Statements).
The outstanding balance of the revolving credit facility was $128,675,000 at December 31, 2007, $142,700,000 at December 31, 2006 and $142,035,000 at December 31, 2005. Interest expense of $8,121,000 increased $759,000 or 10.3% in 2007 compared to interest expense of $7,362,000 in 2006, and increased $2,999,000 or 68.7% in 2006 compared to interest expense of $4,363,000 in 2005. Interest expense increased in 2007 compared to 2006 because we received lower cooperative dividends in 2007 from one of our participating lenders and because we established longer-term interest rate protection which increased the overall effective interest rate. Cooperative dividends are accounted for as an offset to interest expense when earned. In March 2007, we terminated two outstanding interest-rate swap agreements, with original maturities of June 2008, in exchange for $1,936,000 in proceeds. Proceeds of $1,272,000 were recognized as an offset to interest expense during 2007. Without this offset, interest expense would have been $9,393,000 in 2007, an increase of $2,031,000 or 27.6% compared to 2006. The effective interest rate was 5.94%, 5.13% and 4.20% in 2007, 2006 and 2005, respectively.
It is the opinion of management that the effects of inflation on operating revenue and expenses over the past three years have been immaterial. Management anticipates that this trend will continue in the near future.
We paid dividends of $6,357,000, or $0.48 per share, in 2007 and $6,316,000, or $0.48 per share in 2006. We announced a first quarter dividend of $0.12 per share in 2008, and if it is continued at that rate would produce an annual dividend of $0.48 per share. See page 25 for a further discussion of HickoryTechs dividend tendencies and restrictions.
Liquidity and Capital Resources
The total capital structure (long-term and short-term debt obligations plus shareholders equity) for HickoryTech was $161,138,000 at December 31, 2007, reflecting 19.8% equity and 80.2% debt. This compares to a capital structure of $173,175,000 at December 31, 2006, reflecting 17.4% equity and 82.6% debt. Management believes adequate operating cash flows and other internal and external resources are available to finance ongoing operating requirements, including capital expenditures, business development, debt service, temporary financing of trade accounts receivable and the payment of dividends for at least the next 12 months. We employ an extended term payable financing arrangement for inventory purchases in the Enventis Sector and view this arrangement as more of a structured accounts payable that is paid within 60 days with no separate interest charge. As such, the extended term payable financing amount of $14,443,000 and $7,719,000 as of December 31, 2007 and 2006 respectively, is not considered to be part of the Companys capital structure and has been excluded from the above amounts (see Note 8 to the Notes to the Consolidated Financial Statements).
Cash generated from operations was $30,731,000 in 2007, which was primarily attributable to net income plus non-cash expenses, including depreciation and amortization of $19,004,000. The increase in changes in operating assets and liabilities of $9,190,000 from 2006 to 2007 was primarily due to a decrease in the amount of inventory on hand of $11,966,000 along with decreased accounts payable and accrued expenses of $3,123,000, which were offset by an increase in the receivables outstanding as of December 31, 2007 of $3,485,000. The decrease in inventory levels was due to the timing of projects in process in the Enterprise Network Services equipment revenue product line of the Enventis sector.
Cash generated from operations in 2006 was $17,562,000. Cash provided by operations in 2006 was attributable to net income plus non-cash expenses, including depreciation and amortization of $18,121,000 and the loss on discontinued operations totaling $2,967,000. Cash provided by operations in 2006 declined from 2005 by $14,367,000 due to changes in operating assets and liabilities of $14,219,000. The most significant, of which, was an increase in the inventory on hand, offset by a related decrease in prepaid inventory resulting in a net cash usage of $4,116,000, an increase in the outstanding accounts receivable balance of $4,032,000 and a decrease in outstanding accounts payables and accrued expenses of $3,255,000, all of which contributed to lower cash provided by operations. The increase in inventory on hand was the result of supporting the increased projects in process in the Enventis Sector as well as an increase in the average days of inventory on hand. Increased outstanding account receivable balances were primarily the result of the sales growth in the equipment revenue portion of the Enventis Sector and an increase in the average days of sales outstanding. The year 2006, which was the first year of integrated operations with Enventis, was a less typical year for cash flow from operations than 2005.
In 2005, we generated $31,929,000 in cash from operations, primarily attributable to net income plus non-cash expenses, including depreciation and amortization of $15,436,000 and $6,523,000 from the changes in operating assets and liabilities.
Cash used in investing activities was $17,400,000 in 2007, $20,870,000 in 2006 and $56,547,000 in 2005. Capital expenditures were $17,500,000 in 2007, $21,058,000 in 2006 and $19,434,000 in 2005. The $3,558,000 decrease in capital spending from 2007 to 2006 was primarily related to reduced expenditures in our network broadband expansion, which is nearly complete, and a concentrated effort to focus spending on revenue generating products, services and key strategic initiatives. The level of total company capital spending over the next several years is expected to be slightly higher than the level of capital spending in 2007, yet lower than the level experienced in 2006. In 2005, the cash used in investing activities was significantly impacted by the acquisition of Enventis, in the amount of $38,378,000 plus working capital adjustments. In 2005, redemptions of investments totaling $2,100,000 offset cash used in investing activities.
Cash used in financing activities was $13,220,000 in 2007 and was a direct result of the Companys effort to reduce the overall debt level. A decrease in the overall credit facility of $14,025,000 resulted from repayments of $29,525,000, offset by borrowings of $15,500,000. The increase in the extended term payable balance of $6,724,000 was used to facilitate Enventis equipment purchases, which related to sales growth experienced in 2007. In addition, HickoryTech paid dividends in the amount of $6,357,000 in 2007. Cash provided by financing activities of $2,909,000 in 2006 resulted from the use of the extended term payables arrangement in the Enventis Sector of $7,719,000 and the payment of dividends in the amount of $6,316,000. In 2005, cash provided by financing activities was $23,364,000. On December 30, 2005, HickoryTech entered into a $160,000,000 credit agreement with a syndicate of banks (subsequently reduced to a $155,700,000 facility as of December 31, 2007), which amended its previous credit facility. The proceeds were used to repay the outstanding obligations under the previous credit facility, pay fees and expenses associated with the new credit facility and pay costs associated with the acquisition of Enventis. In addition, HickoryTech paid $6,277,000 of dividends in 2005.
Cash used in discontinued operations was $24,000 in 2007 and $118,000 in 2006. Cash provided by discontinued operations was $1,598,000 in 2005. In 2006, cash provided by operating activities was the result of the net operating loss of $927,000, which was offset by a decrease in the accounts receivable balances of $658,000. In 2005, cash provided by operating activities was the result of a reduction in the deferred tax asset of $562,000, a decreased inventory balance of $493,000 and a decrease of $487,000 in project costs that were not billed to customers.
Working capital (i.e. current assets minus current liabilities) was $8,228,000 as of December 31, 2007 compared to working capital of $7,731,000 as of December 31, 2006. The ratio of current assets to current liabilities was 1.3 as of December 31, 2007 and 2006, respectively.
The Enventis Sector has a $20,000,000 wholesale financing agreement with a financing company to fund inventory purchased from certain approved vendors. Advances under the financing arrangement are collateralized by the accounts receivable and inventory of Enventis and a guaranty of an amount up to $16,000,000 by Hickory Tech Corporation. The financing agreement provides sixty-day interest-free payment terms for inventory purchases and can be terminated at any time by either party. The balance outstanding under the financing arrangement was $14,443,000 and $7,719,000 at December 31, 2007 and 2006, respectively. These balances are classified as current liabilities in the accompanying balance sheets and are not considered part of the Companys debt financing.
Our long-term obligations as of December 31, 2007 were $128,475,000, excluding current maturities of $475,000 on debt and $256,000 on current maturities of capital leases. Long-term obligations as of December 31, 2006, were $141,529,000 excluding current maturities of $1,300,000 on debt and $260,000 of capital leases. On December 30, 2005, HickoryTech entered into a $160,000,000 credit agreement with a syndicate of banks (subsequently reduced to a $155,700,000 facility as of December 31, 2007), which amended our previous credit facility. The credit facility is comprised of a $30,000,000 revolving credit component that expires on December 30, 2011 and a $130,000,000 term loan component.
The term loan component is comprised of two components, which are defined as term loan B and term loan C. The outstanding principal balance of term loan B is $106,075,000 as of December 31, 2007, and is held in varying amounts by three of the lenders in the syndicate, US Bank, GE Commercial Distribution Finance Corporation and CoBank. Under the terms of term loan B, we are required to make quarterly principal payments of $275,000 from December 31, 2007 through December 31, 2011 with the remainder of the aggregate principal due in two payments on March 31, 2012 and June 30, 2012. Due to the aggressive pay down of debt in 2007, we are not required to make quarterly principle payments during the first three quarters of 2008. The outstanding principal balance of term loan C is $19,600,000 as of December 31, 2007 and is held entirely by the Rural Telephone Finance Cooperative (RTFC). Under the terms of term loan C, we are required to make quarterly principal payments of $50,000 on the aggregate principal amount from December 31, 2007 through December 31, 2012 with the remainder of the aggregate principal due in two payments on March 31, 2013 and June 30, 2013.
Under the terms of the revolving credit facility, any outstanding principal is payable in full on December 30, 2011. The outstanding balance of the revolving credit facility is $3,000,000 as of December 31, 2007. For all components of the total credit facility, interest is payable at an applicable margin in excess of a prevailing pricing level. The prevailing price level is based on a Base Rate, LIBOR Rate Loans or RTFC rate table. The prevailing rate for Base Rate Loans is the higher of Prime Rate or the Federal Funds Rate plus 0.5%. The prevailing rate for LIBOR Rate Loans is publicly available. The RTFC rate tables are established based on RTFC policies, which are not publicly available and change from time to time. The applicable margin for the revolving credit facility, term loan B and term loan C is determined quarterly based on the leverage ratio of HickoryTech. The credit facility also provides for payment of a fee on any un-drawn commitment of the revolving credit facility and is payable quarterly. The credit facility requires us to enter into or maintain in effect, interest rate protection agreements on at least 50% of the facilitys outstanding balance in order to manage our exposure to interest rate fluctuations. We continually monitor the interest rates on its bank loans and has implemented interest rate protection agreements on various portions of the overall debt outstanding for varying terms. As a result of the new credit agreement, we incurred $1,525,000 of new debt placement costs in 2005, which will be amortized over the expected life of the debt facility.
Our debt requires us to comply, on a consolidated basis, with specified financial ratios and tests. These financial ratios and tests include maximum leverage ratio, minimum interest coverage ratio and maximum capital expenditures. Our obligations under the credit facility are secured by a first-priority lien on all property and assets, tangible and intangible of HickoryTech and its current subsidiaries, including, but not limited to accounts receivable, inventory, equipment and intellectual property; general intangibles, cash and proceeds of the foregoing. HickoryTech has also given a first-priority pledge of the capital stock of HickoryTechs current subsidiaries to secure the credit facility.
Our Telecom Sector leases certain computer equipment under capital lease arrangements. This Sector recorded additions to property, plant and equipment of $522,000, $266,000 and $782,000 in 2007, 2006 and 2005, respectively, related to these capital lease arrangements.
The following table sets forth our contractual obligations, along with the cash payments due each period. Interest on long-term debt is estimated using the interest rate as of December 31, 2007:
(A) Interest on long-term debt is calculated using a variable interest rate. We use interest rate swap agreements to manage our exposure to interest rate movements on a portion of our variable rate debt obligations (see Note 12 to the Notes to the Consolidated Financial Statements).
(B) Purchase obligations consist primarily of commitments incurred for construction projects.
(C) Pension Benefit Obligations consist of the expected net premium payment and life insurance benefits to be paid relative to our Post Retirement Benefit Plan.
In addition, we have change of control agreements with key employees. These potential commitments are not included in the above schedule. Due to the uncertainty of when any FIN No. 48 payments would fall due, we have excluded all payments from the table above.
Off-Balance Sheet Arrangement/Contingent Commitments
We are not engaged in any transactions, arrangements or other relationships with unconsolidated entities or other third parties that are reasonably likely to have a material effect on its liquidity, or on its access to, or requirements for capital resources. In addition, we have not established any special purpose entities.
We have not conducted a public equity offering and operate with original equity capital, retained earnings and indebtedness in the form of bank term and revolving lines of credit. By utilizing cash flow from operations and current cash balances, we believe that we have adequate resources to meet its anticipated operating, capital expenditures and debt service requirements.
Recent Accounting Developments
See Note 1, Accounting Policies Recent Accounting Developments, in the Notes to the Consolidated Financial Statements for a discussion of recent accounting developments.
We do not have operations subject to risks of foreign currency fluctuations. We do, however, use derivative financial instruments to manage exposure to interest rate fluctuations. Our objectives for holding derivatives are to minimize interest rate risks using the most effective methods to eliminate or reduce the impact of these exposures. Variable rate debt instruments are subject to interest rate risk. In March 2007, we terminated two outstanding interest-rate swap agreements, with original maturities of June 2008, in exchange for $1,936,000 in proceeds. Proceeds of $1,272,000 were recognized as an offset to interest expense during 2007. The unrecognized portion of the proceeds is recorded as a component of accumulated other comprehensive income (loss) in shareholders equity and will be recognized as an offset to interest expense over the remaining original term of the agreement (six months ending in June 2008). Immediately following the termination of the two agreements discussed above, we executed a new interest-rate swap agreement, effectively locking in the interest rate on $60,000,000 of variable-rate debt through March of 2010.
The cumulative gain or loss on current derivative instruments is reported as a component of accumulated other comprehensive income (loss) in shareholders equity and is recognized in earnings when the term of the protection agreement is concluded. Our earnings are affected by changes in interest rates as a portion of its long-term debt has variable interest rates based on LIBOR. If interest rates for the portion of our long-term debt based on variable rates had averaged 10% more for the year ended December 31, 2007, our interest expense would have increased $398,000.
Board of Directors and Shareholders
Hickory Tech Corporation
We have audited the accompanying consolidated balance sheet of Hickory Tech Corporation and subsidiaries (the Company) as of December 31, 2007, and the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for the year then ended. Our audit of the basic consolidated financial statements included the financial statement schedule under Item 15(a)(2). These consolidated financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hickory Tech Corporation and subsidiaries as of December 31, 2007, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Note 11 to the consolidated financial statements, effective January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 29, 2008, expressed an unqualified opinion on the effectiveness of the Companys internal control over financial reporting.
Board of Directors and Shareholders
Hickory Tech Corporation
We have audited the internal control over financial reporting of Hickory Tech Corporation and subsidiaries (the Company) as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Companys management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, HickoryTech Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of HickoryTech Corporation and subsidiaries as of December 31, 2007, and the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for the year then ended, and our report dated February 29, 2008, which includes an explanatory paragraph discussing the adoption of Financial Accounting Standards Board Interpretation No. 48, expressed an unqualified opinion on those consolidated financial statements.
To the Shareholder and Board of Directors
Hickory Tech Corporation:
In our opinion, the consolidated balance sheet as of December 31, 2006 and the related consolidated statements of operations, statements of shareholders equity and comprehensive income/(loss) and statement of cash flows for each of two years in the period ended December 31, 2006 present fairly, in all material respects, the financial position of Hickory Tech Corporation and its subsidiaries at December 31, 2006, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for each of the two years in the period ended December 31, 2006 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
HICKORY TECH CORPORATION
Years Ended December 31
(Dollars in thousands, except share and per share amounts)