Quintiles Transnational Holdings Inc. 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
for the fiscal year ended December 31, 2005
for the transition period from to
Commission File No. 001-15577
QWEST COMMUNICATIONS INTERNATIONAL INC.
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
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. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark 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 x.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check One):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
On February 1, 2006, 1,868,988,842 shares of Qwest common stock were outstanding. The aggregate market value of the Qwest voting stock held by non-affiliates as of June 30, 2005 was approximately $4.1 billion.
DOCUMENTS INCORPORATED BY REFERENCE:
Information required by Part III (Items 10, 11, 12, 13 and 14) is incorporated by reference to portions of Qwests definitive proxy statement for its 2006 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission within 120 days of December 31, 2005.
TABLE OF CONTENTS
GLOSSARY OF TERMS
Our industry uses many terms and acronyms that may not be familiar to you. To assist you in reading this document, we have provided below definitions of some of these terms.
Unless the context requires otherwise, references in this report to Qwest, we, us, the Company and our refer to Qwest Communications International Inc. and its consolidated subsidiaries. References in this report to QCII refer to Qwest Communications International Inc. on an unconsolidated, stand-alone basis.
ITEM 1. BUSINESS
We provide local telecommunications and related services, long-distance services and wireless, data and video services within our local service area, which consists of the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We also provide reliable, scalable and secure broadband data and voice (including long-distance) communications services outside our local service area as well as globally.
We were incorporated under the laws of the State of Delaware in 1997. Our principal executive offices are located at 1801 California Street, Denver, Colorado 80202, telephone number (303) 992-1400.
We previously provided directory publishing services in our local service area. In November 2002, we sold our directory publishing business in seven of the 14 states in which we offered these services. In September 2003, we sold the directory publishing business in the remaining states. As a consequence, the results of operations of our directory publishing business are included in income from discontinued operations in our consolidated statements of operations.
For a discussion of certain risks applicable to our business, financial condition and results of operations, including risks associated with our outstanding legal matters, see Risk Factors in Item 1A of this report.
The below table provides a summary of some of our key financial metrics. This information should be read in conjunction with, and is qualified by reference to, our consolidated financial statements and notes thereto in Item 8 of this report and Managements Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this report.
We currently operate in three segments: (1) wireline services; (2) wireless services; and (3) other services. We also maintained, until September 2003, a fourth segment consisting of our directory publishing business. The sale of our directory publishing business was completed in September 2003, as discussed above. As a result, for purposes of calculating the percentages of revenue of our segments provided below, we have excluded the impact
of revenue from our directory publishing business, which is accounted for as discontinued operations in our consolidated statement of operations for the year ended December 31, 2003. For additional financial information about our segments see Managements Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this report and Note 15Segment Information to our consolidated financial statements in Item 8 of this report.
Our revenue by segment, including a breakdown of our revenue by major product category, is as follows:
We market and sell our products and services to mass markets and business customers. In general, our mass markets customers include consumers and small businesses, and our business customers include local, national and global businesses, governmental entities, and public and private educational institutions. We distribute our products and services to these customers through a variety of channels, including direct sales, telemarketing and arrangements with third-party agents. We also provide our products and services to other telecommunications providers who purchase our products and services on a wholesale basis. We distribute our wholesale products and services through direct sales.
Wireline Products and Services
We offer wireline products and services in a variety of categories that help people and businesses communicate. Our wireline products and services are offered through our telecommunications network, a portion of which is located within our local service area (referred to as our in-region network) and a portion of which is located outside of our local service area (referred to as our out-of-region network). Our in-region network consists of all equipment (i.e., voice and data switches) required to process telecommunications within our local service area and forms a portion of the Public Switched Telephone Network. Our in-region network is made up of both copper cables and fiber optic broadband cables and serves approximately 14.7 million access lines in 14 states.
Our out-of-region network consists primarily of data switches and fiber optic broadband cables, extending approximately 138,000 miles to major cities, and enables long-distance voice services and data and Internet services. We rely on our out-of-region network, metropolitan area network fiber rings and in-building rights-of-way to expand service to existing customers and provide service to new customers who have locations on or near a fiber ring or in a building where we have a right-of-way or a physical presence. Our fiber rings allow us to provide customers purchasing our broadband data services with end-to-end connectivity to large and multi-location enterprises and other telecommunications carriers in key United States metropolitan markets. End-to-end connectivity provides customers with the ability to transmit and receive information at high speed through the entire connection path.
The following reflects the key categories of our wireline products and services.
Local voice servicesmass markets, business and wholesale. Through our in-region network, we originate, transport and terminate local voice services within local exchange service territories as defined by state regulators. Through this network, we provide:
On a wholesale basis we provide network transport, billing services and access to our in-region network to other telecommunication providers and wireless carriers. These services allow other telecommunications companies to provide telecommunications services that originate or terminate on our in-region network. We also sell UNEs, which allow our local wholesale customers to use our network or a combination of our network and their own networks to provide local voice and data services to their customers.
Long-distance voice servicesmass markets and business. We provide three types of long-distance communications services to our mass markets and business customers:
Long-distance voice serviceswholesale. We also provide the same three types of long-distance services listed above to our wholesale customers. These customers are other carriers and resellers who buy services from us in large quantities and provide these services to their customers.
Access serviceswholesale. We also provide services to other data and telecommunications providers to connect their customers to their networks so that they can provide long-distance, transport, data, wireless and Internet services.
Data and Internet ServicesMass Markets, Business and Wholesale
We offer a broad range of products and professional services to enable our customers to transport voice, data and video telecommunications at speeds up to 12 gigabits per second. Our customers use these products and services in a variety of ways. Our business customers make internal and external data transmissions, such as transferring files from one location to another. Our mass markets customers access email and the Internet using a variety of connection speeds and pricing packages. Our wholesale customers use our facilities for collocation and use our private line services to connect their customers and their networks to our network.
We provide our data and Internet services in our local service area, nationally and internationally. Some of our data and Internet services are described below.
Also included in our data and Internet services are our VoIP services, which we began offering over the past two years to business and mass market customers. However, our VoIP offerings remain new, and, although we consider them to be strategic products with significant growth potential, we do not expect to recognize a significant amount of revenue from them in 2006.
Wireless Products and Services
In August 2003, we entered into a services agreement with a third-party provider that allows us to resell wireless services, including access to its nationwide PCS wireless network, to mass markets and business customers, primarily within our local service area. We began offering these services under our brand name in March 2004 and provide the services through the third-party providers network. Prior to that date, we offered wireless services over our own network. We market our wireless products and services through our website, partnership relationships, retail stores/kiosks and our sales/call centers. We offer mass markets and business customers a broad range of wireless plans, as well as a variety of custom and enhanced features, such as Call Waiting, Caller ID, 3-Way Calling, Voice Messaging, Enhanced Voice Calling and Two-Way Text Messaging. We also offer an integrated service, which enables customers to use the same telephone number and voice mailbox for their wireless phone as for their home or business phone.
We provide other services that primarily involve the sublease of some of our unused real estate, such as space in our office buildings, warehouses and other properties. The majority of these properties are located in our local service area.
Importance, Duration and Effect of Patents, Trademarks and Copyrights
Either directly or through our subsidiaries, we own or have licenses to various patents, trademarks, trade names, copyrights and other intellectual property necessary to the conduct of our business. We do not believe that the expiration of any of our intellectual property rights, or the non-renewal of those rights, would materially affect our results of operations.
We compete in a rapidly evolving and highly competitive market, and we expect competition to continue to intensify. Regulatory developments and technological advances over the past few years have increased opportunities for alternative communications service providers, which in turn have increased competitive pressures on our business. These alternate providers often face fewer regulations and have lower cost structures than we do. In addition, the telecommunications industry is experiencing an ongoing trend towards consolidation, and several of our competitors have consolidated with other telecommunications providers. The resulting consolidated companies are generally larger, have more financial and business resources and have greater geographical reach than we do.
Our on-going response to industry competition includes initiatives to retain and win-back customers by rolling out new or expanded services such as wireless, in-region long-distance, high-speed Internet, video and VoIP, bundling of expanded feature-rich products and improving the quality of our customer service. We increased our marketing and advertising spending levels in 2005 and have seen increased sales of our bundle and package offerings. The success of these offerings has resulted in increased long-distance and high-speed Internet access revenue (as customers add more products), which partially offsets lower revenue due to access line losses. While bundle discounts result in lower average revenue for our products, we believe they improve customer retention.
Local Voice Services
Although our status as an incumbent local exchange carrier helps make us the leader in providing voice services in our local service area, competition in this market is continually increasing. We continue to compete with traditional telecommunications providers, such as national carriers, smaller regional providers, CLECs and independent telephone companies. Substitution of wireless, cable and Internet-based services for traditional wireline services also continues to increase. As a result, we face greater competition from wireless providers (including ourselves) and broadband service providers, such as cable and Internet companies including VoIP providers.
Competition is based primarily on pricing, packaging of services and features, quality of service and on meeting customer care needs such as simplified billing and timely response to service calls. We believe customers are increasingly looking to receive all of their telephone, television and Internet services from one provider, and as such we and our competitors continue to develop and deploy more innovative product bundling and combined billing options in an effort to retain and gain customers.
Many of our competitors are subject to fewer regulations than we are, which affords them competitive advantages against us. Under federal regulations, traditional telecommunication providers are able to interconnect their networks with ours, resell our local services or lease separate parts of our network (UNEs) in
order to provide competitive local voice services. We generally have been required to provide these functions and services at wholesale rates, which allows our competitors to sell their services at lower prices. However, these rules have been and continue to be under review by state and federal regulators. In connection with rule changes, we have entered into agreements with many of our UNE purchasers, which agreements generally provide for wholesale prices above previously imposed UNE rates. Despite these developments, the ongoing obligation to provide UNEs continues to reduce our overall revenue and margin. For a detailed discussion of regulations affecting our business, see Regulation below. In addition, wireless and broadband service providers generally are subject to less or no regulation, which allows them to operate with lower costs than we are able to operate.
Long-Distance Voice Services
In providing long-distance services, we compete primarily with national telecommunications providers, such as AT&T Inc. (formerly SBC Communications Inc. and AT&T Corp.), Sprint Nextel Corporation and Verizon Communications Inc. (formerly Verizon and MCI, Inc.), and increasingly with wireless providers and broadband service providers, such as cable and Internet companies, including VoIP providers.
Competition in the long-distance market is based primarily on price, customer service, quality and reliability. In addition, competition for business customers is also based on the ability to provide nationwide services, and competition for wholesale customers is also based on available capacity. The national telecommunications providers and wireless and broadband service providers with which we compete often have significant name recognition in the national long-distance markets and as such have been able to retain and/or gain market share. These competitors also have substantial financial and technological resources that allow them to compete more effectively against us. As these competitors have consolidated to form larger companies, their name recognition and financial and technological resources have increased as well.
Data and Internet Services
In providing data and Internet services to our mass markets customers, we compete primarily with broadband service providers, including cable providers and national telecommunications providers. In providing data and Internet services to our business customers, we compete primarily with national telecommunications providers and smaller regional providers. We also compete with large integrators which are increasingly providing customers with WAN services, which take inter-site traffic off of our network.
Competition is based on network reach, as well as quality, reliability, customer service and price. Many of our competitors in this market are not subject to the same regulatory requirements as we are and therefore are able to avoid significant regulatory costs and obligations, such as the obligations to make UNEs available to competitors and to provide competitive access.
The market for wireless services is highly competitive. We compete with national carriers, such as Verizon, Cingular Wireless LLC and Sprint Nextel, as well as regional carriers. We expect competition in this market to continue to increase as additional spectrum is made available within our local service area. This may attract new competitors to the market and may allow current competitors the opportunity to increase their coverage areas and service quality. In 2004 we began offering our wireless services on a resale basis through a service agreement with a third-party provider. Our future competitive position will depend on our ability to retain and gain subscribers through the bundling of these wireless services with our other products and services.
Competition is based on price, coverage area, services, features, handsets, technical quality and customer service.
As a general matter, we are subject to significant state and federal regulation, including requirements and restrictions arising under the Communications Act of 1934, as amended, or the Communications Act, as modified in part by the Telecommunications Act of 1996, or the Telecommunications Act, state utility laws, and the rules and policies of the Federal Communications Commission, or FCC, state regulators and other governmental entities. Federal laws and FCC regulations generally apply to regulated interstate telecommunications (including international telecommunications that originate or terminate in the United States), while state regulatory authorities generally have jurisdiction over regulated telecommunications services that are intrastate in nature. The local competition aspects of the Telecommunications Act are subject to FCC rulemaking, but the state regulatory authorities play a significant role in implementing some FCC rules. Generally, we must obtain and maintain certificates of authority from regulatory bodies in most states where we offer regulated services and must obtain prior regulatory approval of rates, terms and conditions for our intrastate services, where required.
This structure of public utility regulation generally prescribes the rates, terms and conditions of our regulated wholesale and retail products and services (including those sold or leased to CLECs). While there is some commonality among the regulatory frameworks from jurisdiction to jurisdiction, each state has its own unique set of constitutional provisions, statutes, regulations, stipulations and practices that impose restrictions or limitations on the regulated entities activities. For example, in varying degrees, jurisdictions may provide limited restrictions on the manner in which a regulated entity can interact with affiliates, transfer assets, issue debt and engage in other business activities.
The FCC is continuing to interpret the obligations of ILECs under the Telecommunications Act to interconnect their networks with and make UNEs available to other telecommunications providers. These decisions establish our obligations in our local service area and affect our ability to compete outside of our local service area. On February 5, 2005, the FCC issued new unbundling rules to replace the unbundling rules that earlier were vacated by the D.C. Circuit Court of Appeals. The new rules, among other things: (i) require ILECs to provide unbundled access to certain medium to high capacity transport services in the vast majority of their wire centers; and (ii) allow CLECs to convert certain medium to high capacity transport services to UNEs or combinations of UNEs, as long as the CLECs meet applicable qualification requirements. These rules require somewhat less unbundling than the unbundling rules they replaced. QCII and other regional bell operating companies filed a petition for review of this order with the D.C. Circuit Court of Appeals, asserting that the FCCs new unbundling rules are overly broad. Petitions for review filed by other parties claim that the FCC should have adopted more extensive unbundling requirements. Briefing of the appeals has been completed, and oral argument is scheduled for March 21, 2006. A decision is expected mid-year 2006. Similarly, the FCC provided us additional limited unbundling relief in our Omaha, Nebraska service area in response to a petition for forbearance we filed.
On October 4, 2005, Qwest filed a petition asking the FCC to forbear from enforcing the ILECs obligation to convert medium to high capacity transport services to UNEs when the conversion request is made by the companies resulting from the recent mergers of AT&T with SBC and MCI with Verizon. The FCC is currently seeking comment on Qwests petition. A grant of Qwests petition would ensure that a large portion of Qwests medium to high capacity transport services will not be converted to UNEs, which provide approximately half the revenue as medium to high capacity transport services. A decision from the FCC is expected in late 2006 or early 2007.
On September 15, 2003, the FCC released a notice of proposed rulemaking, instituting a comprehensive review of the rules pursuant to which UNEs are priced and on how the discounts to CLECs are established for their intended resale of our services. In particular, the FCC indicated that it will re-evaluate the rules and principles surrounding Total Element Long Run Incremental Cost, which is the basis upon which UNE prices are set. The outcome of this rulemaking could have a material effect on the revenue and margins associated with our provision of UNEs to CLECs.
Intercarrier Compensation and Access Pricing
The FCC has initiated over the past five years a number of proceedings that do, and will, affect the rates and charges for access services that we sell to or purchase from other carriers. In 2005, the FCC released a further notice of proposed rulemaking in the pending intercarrier compensation docket, and parties filed comments addressing issues raised in the FCC notice and various industry group proposals for revising the intercarrier compensation regime. The rules emanating from this rulemaking could result in fundamental changes in the charges we collect from other carriers and our end-users. This proceeding has not yet been completed, and, because of its complexity and economic significance, may not be completed for some time. This complexity is due in part to the advent of new types of traffic (such as VoIP) for which accurate billing is difficult to assure or verify (sometimes referred to as phantom traffic). The FCC may address discrete intercarrier compensation issues, such as compensation for phantom traffic, prior to completing comprehensive reform. Also, there has been a national trend toward reducing the amounts charged for use of our networks to terminate all types of calls, with a corresponding shift of costs to end users. From time to time, the state regulators that regulate intrastate access charges conduct proceedings that may affect the rates and charges for access services.
On October 18, 2004, in a related docket the FCC released an Order deciding to forbear from applying certain ISP reciprocal compensation interim rules adopted in an April 27, 2001 Order. Those particular interim rules related to the cap on the number of minutes of use and the requirement that carriers exchange ISP-bound traffic on a bill-and-keep basis if those carriers were not exchanging traffic pursuant to interconnection agreements prior to adoption of the April 27, 2001 Order. This order is currently pending appeal before the D.C. Circuit Court of Appeals. The effect of this Order, and resolution of the pending appeals, may be to increase significantly our payments of reciprocal compensation. In some instances, existing state rules regarding reciprocal compensation and applicable interconnection agreements limit the effect of this Order.
On January 31, 2005, the FCC initiated a proceeding to examine whether ILEC special access rates should be reduced and pricing flexibility for those services should be curtailed. Reply comments in this proceeding were filed on July 29, 2005. This proceeding is pending before the FCC.
Voice Over Internet Protocol and Broadband Internet Access Services
On September 22, 2003, Vonage Holdings Corporation filed a petition for declaratory ruling requesting that the FCC preempt an order of the Minnesota Public Utilities Commission imposing regulations applicable to providers of telephone service on Vonages DigitalVoice, an IP based voice service sold to retail customers. On November 12, 2004, the FCC released its unanimous decision finding that preemption of state telecommunication service regulation was consistent with federal law and policies intended to promote the continued development of the Internet, broadband and interactive services. The FCC further concluded that divergent state rules, regulations and licensing requirements could impede the rollout of such services that benefit consumers by providing them with more choice, competition and innovation. An appeal of the FCCs order is currently pending before the Eighth Circuit Court of Appeals.
On March 10, 2004, the FCC issued its notice of proposed rulemaking instituting a formal rulemaking proceeding, or the IP-Enabled Services Proceeding, addressing many issues related to VoIP and other Internet services. This rulemaking raises issues that overlap, to a degree, with the rulemakings concerning ILEC Broadband Telecommunications Services and Intercarrier Compensation. There are a number of issues that have been presented to the FCC that concern VoIP and that could affect intercarrier compensation requirements and other federal or state requirements, such as those that impose a fee to support universal service and programs that support the extension of telecommunications and Internet facilities to rural areas and to public schools and facilities in inner cities. The FCC has also stated that the question of whether such IP based services should be classified as an unregulated information service under the Communications Act or as telecommunications services will be addressed in this proceeding. The FCC will also address in this proceeding whether VoIP providers must pay carrier access charges or intercarrier compensation, whether they must contribute to the universal service fund, and other issues involving IP-enabled services, including access by disabled persons, applicability of law enforcement statutes and the provision of emergency (911) services. This docket remains
pending. In a separate, but related, rulemaking the FCC has issued rules requiring all VoIP providers to offer 911 service in conjunction with their VoIP services. We are following these developments closely, as our network is capable of VoIP transport and other combinations of voice and data in an IP-addressed packet format. VoIP offerings are likely to grow as the technology matures and the regulatory situation is clarified, and such growth in VoIP could contribute to further declines in our sales of traditional local exchange access lines or local exchange services.
On September 23, 2005, the FCC issued an order reclassifying certain ILEC wireline broadband Internet access offerings as information services no longer subject to tariffing obligations. We have notified the FCC that we are eliminating these offerings from our federal tariffs, which will allow us to tailor our wireline broadband Internet access offerings to specific customer needs. A petition for review of the FCCs order is currently pending before the Third Circuit Court of Appeals.
The FCC maintains a number of universal service programs that are intended to ensure affordable telephone service for all Americans, including low-income consumers and those living in rural areas that are costly to serve, and ensure access to advanced telecommunications services for schools, libraries, and rural health care providers. These programs, which currently total over $6 billion annually, are funded through contributions by interstate telecommunications carriers, which are generally passed through to their end users. Currently, universal service contributions are assessed at a rate of approximately 10 percent of interstate and international end user telecommunications revenues. The FCC is actively considering a new contribution methodology based on telephone numbers, which could significantly increase our universal service contributions, and potentially affect the demand for certain telecommunications services. If a telephone number contribution methodology is adopted it will likely apply to all wireline, wireless and VoIP service providers.
Qwest is also currently the recipient of over $80 million annually in federal universal service subsidies (excluding amounts received through the schools, libraries, and rural health care programs). The FCC is actively considering changes in the structure and distribution methodology of its universal service programs. The resolution of these proceedings ultimately could affect the amount of universal service support we receive.
As of December 31, 2005, we employed approximately 39,000 people.
Approximately 23,000 of our employees are represented by collective bargaining agreements with the Communications Workers of America, or CWA, and the International Brotherhood of Electrical Workers, or IBEW. In August 2005, we reached agreements with the CWA and the IBEW on new three-year labor agreements. Each of these agreements was ratified by union members and expires on August 16, 2008.
Financial Information about Geographic Areas
We provide a variety of telecommunications services on a domestic and international basis to business, government, mass markets and wholesale customers; however, our internationally-based customers do not result in a material amount of revenue to us.
Our website address is www.qwest.com. The information contained on, or that may be accessed through, our website is not part of this annual report. You may obtain free electronic copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports at our investor relations website, www.qwest.com/about/investor/, under the heading SEC Filings. These reports are available on our investor relations website as soon as reasonably practicable after we electronically file them with the Securities and Exchange Commission, or SEC.
We have adopted written codes of conduct that serve as the code of ethics applicable to our directors, officers and employees, including our principal executive officer and senior financial officers, in accordance with Section 406 of the Sarbanes-Oxley Act of 2002, the rules of the SEC promulgated thereunder and the New York Stock Exchange rules. In the event that we make any changes to, or provide any waivers from, the provisions of our codes of conduct, we intend to disclose these events on our website or in a report on Form 8-K within four business days of such event.
These codes of conduct, as well as copies of our guidelines on significant governance issues and the charters of our audit committee, compensation and human resources committee and nominating and governance committee, are available on our website at www.qwest.com/about/investor/governance or in print to any stockholder who requests them by sending a written request to our Corporate Secretary at Qwest Communications International Inc., 1801 California Street, Denver, Colorado 80202.
Special Note Regarding Forward-Looking Statements
This Form 10-K contains or incorporates by reference forward-looking statements about our financial condition, results of operations and business. These statements include, among others:
These statements may be made expressly in this document or may be incorporated by reference to other documents we have filed or will file with the SEC. You can find many of these statements by looking for words such as may, would, could, should, plan, believes, expects, anticipates, estimates, or similar expressions used in this document or documents incorporated by reference in this document.
These forward-looking statements are subject to numerous assumptions, risks and uncertainties that may cause our actual results to be materially different from any future results expressed or implied by us in those statements. Some of these risks are described in Risk Factors in Item 1A of this report.
These risk factors should be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on our behalf may issue. Given these uncertainties, we caution investors not to unduly rely on our forward-looking statements. We do not undertake any obligation to review or confirm analysts expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events. Further, the information about our intentions contained in this document is a statement of our intention as of the date of this document and is based upon, among other things, the existing regulatory environment, industry conditions, market conditions and prices, the economy in general and our assumptions as of such date. We may change our intentions, at any time and without notice, based upon any changes in such factors, in our assumptions or otherwise.
ITEM 1A. RISK FACTORS
Risks Affecting Our Business
Increasing competition, including product substitution, continues to cause access line losses, which could adversely affect our operating results and financial performance.
We compete in a rapidly evolving and highly competitive market, and we expect competition to continue to intensify. We are facing greater competition in our core local business from cable companies, wireless providers (including ourselves), facilities-based providers using their own networks as well as those leasing parts of our
network (UNEs), and resellers. As a reseller of wireless services, we face risks that facility based wireless providers do not have. In addition, regulatory developments over the past few years have generally increased competitive pressures on our business. Due to these and other factors, we continue to lose access lines and are experiencing pressure on profit margins.
We seek to distinguish ourselves from our competitors by providing new or expanded services such as in-region long-distance, high-speed Internet, wireless, video and VoIP, bundling of expanded feature-rich products and improving the quality of our customer service. However, we may not be successful in these efforts. We may not have sufficient resources to distinguish our service levels from those of our competitors, and we may not be successful in integrating our product offerings, especially products for which we act as a reseller, such as wireless services and satellite video services. Even if we are successful, these initiatives may not be sufficient to offset our continuing loss of access lines. If these initiatives are unsuccessful or insufficient and our revenue declines significantly without corresponding cost reductions, this will cause a significant deterioration to our results of operations and financial condition and adversely affect our ability to service debt and pay other obligations.
Consolidation among participants in the telecommunications industry may allow our competitors to compete more effectively against us, which could adversely affect our operating results and financial performance.
The telecommunications industry is experiencing an ongoing trend towards consolidation, and several of our competitors have consolidated with other telecommunications providers. This trend may result in competitors that are larger and better financed and may afford our competitors increased resources and greater geographical reach, thereby enabling such competitors to compete more effectively against us. We have begun to experience and expect further increased pressures as a result of this trend and in turn have been and may continue to be forced to respond with lower profit margin product offerings and pricing plans in an effort to retain and attract customers. These pressures could adversely affect our operating results and financial performance.
Rapid changes in technology and markets could require substantial expenditure of financial and other resources in excess of contemplated levels, and any inability to respond to those changes could reduce our market share.
The telecommunications industry is experiencing significant technological changes, and our ability to execute our business plans and compete depends upon our ability to develop and deploy new products and services, such as broadband data, wireless, video and VoIP services. The development and deployment of new products and services could require substantial expenditure of financial and other resources in excess of contemplated levels. If we are not able to develop new products and services to keep pace with technological advances, or if such products and services are not widely accepted by customers, our ability to compete could be adversely affected and our market share could decline. Any inability to keep up with changes in technology and markets could also adversely affect the trading price of our securities and our ability to service our debt.
Third parties may claim we infringe upon their intellectual property rights, and defending against these claims could adversely affect our profit margins and our ability to conduct business.
From time to time, we receive notices from third parties claiming we have or are infringing upon their intellectual property rights. We may receive similar notices in the future. Responding to these claims may require us to expend significant time and money defending our use of affected technology, may require us to enter into royalty or licensing agreements on less favorable terms than we could otherwise obtain or may require us to pay damages. If we are required to take one or more of these actions, our profit margins may decline. In addition, in responding to these claims, we may be required to stop selling or redesign one or more of our products or services, which could significantly and adversely affect the way we conduct business.
Risks Relating to Legal and Regulatory Matters
Any adverse outcome of the investigation currently being conducted by the DOJ or the material litigation pending against us, including the securities actions, could have a material adverse impact on our financial condition and operating results, on the trading price of our debt and equity securities and on our ability to access the capital markets.
The DOJ investigation and the remaining securities actions described in Legal Proceedings in Item 3 of this report present material and significant risks to us. In the aggregate, the plaintiffs in the remaining securities actions seek billions of dollars in damages, and the outcome of one or more of these actions or the DOJ investigation could have a negative impact on the outcomes of the other actions. Further, the size, scope and nature of the restatements of our consolidated financial statements for 2001 and 2000, which are described in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2002, affect the risks presented by these actions and the DOJ investigation, as these matters involve, among other things, our prior accounting practices and related disclosures. Plaintiffs in certain of the securities actions have alleged our restatement of items in support of their claims. We continue to defend against the remaining securities actions vigorously and are currently unable to provide any estimate as to the timing of their resolution.
We can give no assurance as to the impacts on our financial results or financial condition that may ultimately result from all of these matters. We have recorded reserves in our financial statements representing the minimum estimated amount of loss we believe is probable with respect to the securities actions. However, the ultimate outcomes of these matters are still uncertain and the amount of loss we ultimately incur could be substantially more than the reserves we have provided. If the recorded reserves are insufficient, we will need to record additional charges to our consolidated statement of operations in future periods. In addition, any settlement of or judgment in one or more of these actions substantially in excess of our recorded reserves could have a significant impact on us, and we can give no assurance that we will have the resources available to pay any such judgment. The magnitude of any settlement or judgment resulting from these matters could materially and adversely affect our ability to meet our debt obligations and our financial condition, potentially impacting our credit ratings, our ability to access capital markets and our compliance with debt covenants. In addition, the magnitude of any settlement or judgment may cause us to draw down significantly on our cash balances, which might force us to obtain additional financing or explore other methods to generate cash. Such methods could include issuing additional securities or selling assets.
Further, there exist other material proceedings pending against us as described in Legal Proceedings in Item 3 of this report, which, depending on their outcome, may have a material adverse effect on our financial position. Thus, we can give no assurances as to the impacts on our financial results or financial condition as a result of these matters.
Current or future civil or criminal actions against our former officers and employees could reduce investor confidence and cause the trading price for our securities to decline.
As a result of our past accounting issues, investor confidence in us has suffered and could suffer further. Although we have consummated a settlement with the SEC concerning its investigation of us, in March 2005, the SEC filed suit against our former chief executive officer, Joseph Nacchio, two of our former chief financial officers, Robert Woodruff and Robin Szeliga, and other former officers and employees. In December 2005, a criminal indictment was filed against Mr. Nacchio charging him with 42 counts of insider trading. In July 2005, Ms. Szeliga pleaded guilty to a criminal charge of insider trading. In December 2005, Marc Weisberg, a former Qwest executive, pleaded guilty to a criminal charge of wire fraud. Other former officers or employees have entered into settlements with the SEC involving civil fraud or other claims in which they neither admitted nor denied the allegations against them.
A trial could take place in the pending SEC lawsuit against Mr. Nacchio and others and in connection with the criminal charges against Mr. Nacchio. Evidence introduced at such trials and in other matters may result in
further scrutiny by governmental authorities and others. The existence of this heightened scrutiny could adversely affect investor confidence and cause the trading price for our securities to decline.
We operate in a highly regulated industry, and are therefore exposed to restrictions on our manner of doing business and a variety of claims relating to such regulation.
Our operations are subject to significant federal regulation, including the Communications Act and FCC regulations thereunder. We are also subject to the applicable laws and regulations of various states, including regulation by PUCs and other state agencies. Federal laws and FCC regulations generally apply to regulated interstate telecommunications (including international telecommunications that originate or terminate in the United States), while state regulatory authorities generally have jurisdiction over regulated telecommunications services that are intrastate in nature. The local competition aspects of the Telecommunications Act are subject to FCC rulemaking, but the state regulatory authorities play a significant role in implementing those FCC rules. Generally, we must obtain and maintain certificates of authority from regulatory bodies in most states where we offer regulated services and must obtain prior regulatory approval of rates, terms and conditions for our intrastate services, where required. Our businesses are subject to numerous, and often quite detailed, requirements under federal, state and local laws, rules and regulations. Accordingly, we cannot ensure that we are always in compliance with all these requirements at any single point in time. The agencies responsible for the enforcement of these laws, rules and regulations may initiate inquiries or actions based on their own perceptions of our conduct, or based on customer complaints. See BusinessRegulation in Item 1 of this report for further information about regulations affecting our business.
Regulation of the telecommunications industry is changing rapidly, and the regulatory environment varies substantially from state to state. Recently a number of state legislatures and state PUCs adopted reduced or modified forms of regulation for retail services. This is generally beneficial to us because it reduces regulatory costs and regulatory filing and reporting requirements. These changes also generally allow more flexibility for new product introduction and enhance our ability to respond to competition. At the same time, some of the changes, occurring at both the state and federal level, may have the potential effect of reducing some regulatory protections, including having FCC-approved tariffs that include rates, terms and conditions. These changes may necessitate the need for customer-specific contracts to address matters previously covered in our tariffs. Despite these regulatory changes, a substantial portion of our local voice services revenue remains subject to FCC and state PUC pricing regulation, which could expose us to unanticipated price declines. There can be no assurance that future regulatory, judicial or legislative activities will not have a material adverse effect on our operations, or that regulators or third parties will not raise material issues with regard to our compliance or noncompliance with applicable regulations.
All of our operations are also subject to a variety of environmental, safety, health and other governmental regulations. We monitor our compliance with federal, state and local regulations governing the discharge and disposal of hazardous and environmentally sensitive materials, including the emission of electromagnetic radiation. Although we believe that we are in compliance with such regulations, any such discharge, disposal or emission might expose us to claims or actions that could have a material adverse effect on our business, financial condition and operating results.
Risks Affecting Our Liquidity
Our high debt levels pose risks to our viability and may make us more vulnerable to adverse economic and competitive conditions, as well as other adverse developments.
We are highly leveraged. As of December 31, 2005, our total debt was approximately $15.5 billion. Approximately $2.1 billion of our debt obligations comes due over the next three years. While we currently believe we will have the financial resources to meet our obligations when they come due, we cannot anticipate what our future condition will be. We may have unexpected costs and liabilities and we may have limited access to financing.
We may periodically need to obtain financing in order to meet our debt obligations as they come due. We may also need to obtain additional financing or investigate other methods to generate cash (such as further cost reductions or the sale of assets) if revenue and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase or if we become subject to significant judgments, settlements and/or tax payments as further discussed in Legal Proceedings in Item 3 of this report and in Managements Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources in Item 7 of this report. We can give no assurance that such additional financing will be available on terms that are acceptable. Also, we may be impacted by factors relating to or affecting our liquidity and capital resources due to perception in the market, impacts on our credit ratings or provisions in our financing agreements that may restrict our flexibility under certain conditions.
In October 2005, our wholly owned subsidiary, Qwest Services Corporation, replaced its preexisting three-year $750 million revolving credit facility with a new five-year $850 million revolving credit facility (referred to as the 2005 QSC Credit Facility). The facility is currently undrawn. The 2005 QSC Credit Facility has a cross payment default provision, and the 2005 QSC Credit Facility and certain of our other debt issues have cross acceleration provisions. When present, such provisions could have a wider impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. Any such event could adversely affect our ability to conduct business or access the capital markets and could adversely impact our credit ratings. In addition, the 2005 QSC Credit Facility contains various limitations, including a restriction on using any proceeds from the facility to pay settlements or judgments relating to the DOJ investigation and securities actions discussed in Legal Proceedings in Item 3 of this report.
Our high debt levels could adversely impact our credit ratings. Additionally, the degree to which we are leveraged may have other important limiting consequences, including the following:
We may be unable to significantly reduce the substantial capital requirements or operating expenses necessary to continue to operate our business, which may in turn affect our operating results.
The industry in which we operate is capital intensive, and as such we anticipate that our capital requirements will continue to be significant in the coming years. Although we have reduced our capital expenditures and operating expenses over the past year, we may be unable to further significantly reduce these costs, even if revenue is decreasing. While we believe that our current level of capital expenditures will meet both our maintenance and our core growth requirements going forward, this may not be the case if circumstances underlying our expectations change.
Declines in the value of qualified pension plan assets, or unfavorable changes in laws or regulations that govern pension plan funding, could require us to provide significant amounts of funding for our qualified pension plan.
While we do not expect to be required to make material cash contributions to our qualified defined benefit pension plan in the near term based upon current actuarial analyses and forecasts, a significant decline in the value of qualified pension plan assets in the future or unfavorable changes in laws or regulations that govern pension plan funding could materially change the timing and amount of required pension funding. As a result, we may be required to fund our qualified defined benefit pension plan with cash from operations, perhaps by a material amount. Also, recognition of an additional minimum liability caused by changes in pension plan assets
or measurement of the accumulated benefit obligation could have a material impact on our consolidated balance sheet. As an example, if our accumulated benefit obligation exceeds pension plan assets in the future, the impact would be to eliminate our prepaid pension asset, which was $1.165 billion as of December 31, 2005, and record a pension liability for the amount that our accumulated benefit obligation exceeds pension plan assets with a corresponding charge to other comprehensive loss, thereby increasing stockholders deficit. Alternatively, we could make a voluntary contribution to the plan so that the qualified pension plan assets exceed the accumulated benefit obligation. As of December 31, 2005, our qualified pension plan assets exceed our accumulated benefit obligation by $596 million.
Our debt agreements allow us to incur significantly more debt, which could exacerbate the other risks described herein.
The terms of our debt instruments permit us to incur additional indebtedness. Such additional debt may be necessary for many reasons, including to adequately respond to competition, to comply with regulatory requirements related to our service obligations or for financial reasons alone. Incremental borrowings or borrowings at maturity on terms that impose additional financial risks to our various efforts to improve our financial condition and results of operations could exacerbate the other risks described herein.
If we pursue and are involved in any business combinations, our financial condition could be adversely affected.
On a regular and ongoing basis, we review and evaluate other businesses and opportunities for business combinations that would be strategically beneficial. As a result, we may be involved in negotiations or discussions that, if they were to result in a transaction, could have a material effect on our financial condition (including short-term or long-term liquidity) or short-term or long-term results of operations.
Should we make an error in judgment when identifying an acquisition candidate, or should we fail to successfully integrate acquired operations, we will likely fail to realize the benefits we intended to derive from the acquisition and may suffer other adverse consequences. Acquisitions involve a number of other risks, including:
We can give no assurance that we will be able to successfully complete and integrate strategic acquisitions.
Other Risks Relating to Qwest
If conditions or assumptions differ from the judgments, assumptions or estimates used in our critical accounting policies, the accuracy of our financial statements and related disclosures could be affected.
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States, or GAAP, requires management to make judgments, assumptions and estimates that affect the amounts reported in our consolidated financial statements and accompanying notes. Our critical accounting policies, which are described in this document, describe those significant accounting policies and methods used in the preparation of our consolidated financial statements that are considered critical because they require judgments, assumptions and estimates that materially impact our consolidated financial
statements and related disclosures. As a result, if future events differ significantly from the judgments, assumptions and estimates in our critical accounting policies, such events or assumptions could have a material impact on our consolidated financial statements and related disclosures.
Taxing authorities may determine we owe additional taxes relating to various matters, which could adversely affect our financial results.
As a significant taxpayer, we are subject to frequent and regular audits from the Internal Revenue Service, or IRS, as well as from state and local tax authorities. These audits could subject us to risks due to adverse positions that may be taken by these tax authorities. Please see Legal Proceedings in Item 3 of this report for examples of legal proceedings involving some of these adverse positions. For example, in the fourth quarter of 2004, Qwest received notices of proposed adjustments on several significant issues for the 1998-2001 audit cycle. Certain of these proposed adjustments are before the Appeals Office of the IRS. There is no assurance that we and the IRS will achieve settlements on these issues or that, if we do achieve settlements, the terms will be favorable to us. Additionally, the IRS indicated in January 2005 that it is reviewing Qwests tax treatment of the sale of its DEX directory publishing business in the 2002-2003 audit cycle.
Because prior to 1999 Qwest was a member of affiliated groups filing consolidated U.S. federal income tax returns, we could be severally liable for tax examinations and adjustments not directly applicable to current members of the Qwest affiliated group. Tax sharing agreements have been executed between us and previous affiliates, and we believe the liabilities, if any, arising from adjustments to tax liability would be borne by the affiliated group member determined to have a deficiency under the terms and conditions of such agreements and applicable tax law. We have not provided in our financial statements for any liability of former affiliated members or for claims they have asserted or may assert against us.
While we believe our tax reserves adequately provide for the associated tax contingencies, Qwests tax audits and examinations may result in tax liabilities that differ materially from those we have recorded in our consolidated financial statements. Also, the ultimate outcomes of all of these matters are uncertain, and we can give no assurance as to whether an adverse result from one or more of them will have a material effect on our financial results, including potentially offsetting a significant portion of our existing net operating losses.
If we fail to extend or renegotiate our collective bargaining agreements with our labor unions as they expire from time to time, or if our unionized employees were to engage in a strike or other work stoppage, our business and operating results could be materially harmed.
We are a party to collective bargaining agreements with our labor unions, which represent a significant number of our employees. In August 2005, we reached agreements with the CWA and the IBEW on three-year labor agreements. Each of these agreements was ratified by union members and expires on August 16, 2008. Although we believe that our relations with our employees are satisfactory, no assurance can be given that we will be able to successfully extend or renegotiate our collective bargaining agreements as they expire from time to time. The impact of future negotiations, including changes in wages and benefit levels, could have a material impact on our financial results. Also, if we fail to extend or renegotiate our collective bargaining agreements, if disputes with our unions arise, or if our unionized workers engage in a strike or other work stoppage, we could incur higher ongoing labor costs or experience a significant disruption of operations, which could have a material adverse effect on our business.
The trading price of our securities could be volatile.
In recent years, the capital markets have experienced extreme price and volume fluctuations. The overall market and the trading price of our securities may fluctuate greatly. The trading price of our securities may be significantly affected by various factors, including:
ITEM 2. PROPERTIES
Our principal properties do not lend themselves to simple description by character and location. The percentage allocation of our gross investment in property, plant and equipment consisted of the following as of December 31, 2005 and 2004:
Land and buildings consist of land, land improvements, central office and certain administrative office buildings. Communications equipment primarily consists of switches, routers and transmission electronics. Other network equipment primarily includes conduit and cable. General-purpose computers and other consist principally of computers, office equipment, vehicles and other general support equipment. We own substantially all of our telecommunications equipment required for our business. Total gross investment in property, plant and equipment was approximately $46.0 billion and $45.4 billion at December 31, 2005 and 2004, respectively, before deducting accumulated depreciation.
We own and lease sales offices in major metropolitan locations both in the United States and internationally. Our network management centers are located primarily in buildings that we own at various locations in geographic areas that we serve. Substantially all of the installations of central office equipment for our local service business are located in buildings and on land that we own. Our out-of-region network is generally located in real property pursuant to an agreement with the property owner or another person with rights to the property. It is possible that we may lose our rights under one or more of such agreements, due to their termination or their expiration. In addition, several putative class actions have been filed against us disputing our use of certain of such rights-of-way. For a description of these actions, see Legal Proceedings in Item 3 of this report. If we lose any such rights-of-way or are unable to renew them, we may find it necessary to move or replace the affected portions of the network. However, we do not expect any material adverse impacts as a result of the loss of any such rights. For additional information, please see Note 4Property, Plant and Equipment to our consolidated financial statements in Item 8 of this report.
ITEM 3. LEGAL PROCEEDINGS
Throughout this section, when we refer to a class action as putative it is because a class has been alleged, but not certified in that matter. Until and unless a class has been certified by the court, it has not been established
that the named plaintiffs represent the class of plaintiffs they purport to represent. To the extent appropriate, we have provided reserves for each of the matters described below.
Settlement of Consolidated Securities Action
Twelve putative class actions purportedly brought on behalf of purchasers of our publicly traded securities between May 24, 1999 and February 14, 2002 have been consolidated into a consolidated securities action pending in federal district court in Colorado. The first of these actions was filed on July 27, 2001. Plaintiffs allege, among other things, that defendants issued false and misleading financial results and made false statements about our business and investments, including making materially false statements in certain of our registration statements. The most recent complaint in this matter seeks unspecified compensatory damages and other relief. However, counsel for plaintiffs indicated that the putative class would seek damages in the tens of billions of dollars. The SPA action described below has also been consolidated with the consolidated securities action.
On November 23, 2005, we, certain other defendants, and the putative class representatives entered into and filed with the federal district court in Colorado a Stipulation of Partial Settlement that, if implemented, will settle the consolidated securities action against us and certain other defendants. On January 5, 2006, the federal district court in Colorado issued an order (1) preliminarily approving the proposed settlement, (2) setting a hearing for May 19, 2006 to consider final approval of the proposed settlement, and (3) certifying a class, for settlement purposes only, on behalf of purchasers of our publicly traded securities between May 24, 1999 and July 28, 2002.
Under the proposed settlement agreement, we would pay a total of $400 million in cash$100 million of which was paid 30 days after preliminary approval of the proposed settlement by the federal district court in Colorado, $100 million of which would be paid 30 days after final approval of the settlement by the court, and $200 million of which would be paid on January 15, 2007, plus interest at 3.75% per annum on the $200 million between the date of final approval by the court and the date of payment.
If approved, the proposed settlement agreement will settle the individual claims of the class representatives and the claims of the class they represent against us and all defendants in the consolidated securities action, except Joseph Nacchio, our former chief executive officer, and Robert Woodruff, our former chief financial officer. (The non-class action brought by SPA that is consolidated for certain purposes with the consolidated securities action is not part of the settlement.) As part of the proposed settlement, we would receive $10 million from Arthur Andersen LLP, which would also be released by the class representatives and the class they represent, which will offset $10 million of the $400 million that would be payable by us.
The proposed settlement agreement is subject to a number of conditions and future contingencies. Among others, it (i) requires final court approval; (ii) provides plaintiffs with the right to terminate the settlement if the $250 million we previously paid to the SEC in settlement of its investigation against us is not distributed to the class members; (iii) provides us with the right to terminate the settlement if class members representing more than a specified amount of alleged securities losses elect to opt out of the settlement; (iv) provides us with the right to terminate the settlement if we do not receive adequate protections for claims relating to substantive liabilities of non-settling defendants; and (v) is subject to review on appeal even if the district court were finally to approve it. Any lawsuits that may be brought by parties opting out of the settlement will be vigorously defended regardless of whether the settlement described herein is consummated. No parties admit any wrongdoing as part of the proposed settlement.
DOJ Investigation and Remaining Securities Actions
The Department of Justice, or DOJ, investigation and the securities actions described below present material and significant risks to us. The size, scope and nature of the restatements of our consolidated financial statements for 2001 and 2000, which are described in our previously issued consolidated financial statements for the year
ended December 31, 2002, or our 2002 Financial Statements, affect the risks presented by this investigation and these actions, as these matters involve, among other things, our prior accounting practices and related disclosures. Plaintiffs in certain of the securities actions have alleged our restatement of items in support of their claims. We can give no assurance as to the impacts on our financial results or financial condition that may ultimately result from all of these matters.
We have a reserve recorded in our financial statements of approximately $105 million relating to the remaining securities actions described below, which amount represents the minimum estimated amount of loss we believe is probable with respect to these matters. We have recorded our estimate of the minimum liability of these matters because no estimate of probable loss for these matters is a better estimate than any other amount. If the recorded reserve is insufficient to cover these matters, we will need to record additional charges to our consolidated statement of operations in future periods. Additionally, we are unable at this time to provide a reasonable estimate of the upper end of the range of loss associated with these matters due to their complex nature and current status, and, as a result, the amount we have reserved for these matters is our estimate of the lowest end of the possible range of loss. The ultimate outcomes of these matters are still uncertain and the amount of loss we may ultimately incur could be substantially more than the reserve we have provided.
We believe that it is probable that a portion of the recorded reserve for the remaining securities actions described below and the consolidated securities action described above will be recoverable from a portion of the insurance proceeds that were placed in a trust to cover our losses and the losses of individual insureds following our November 2003 settlement of disputes with certain of our insurance carriers related to, among other things, the DOJ investigation and securities actions. The insurance proceeds are subject to claims by us and other insureds for, among other things, the costs of defending certain matters and, as a result, such proceeds are being depleted over time. In any event, the terms and conditions of applicable bylaws, certificates or articles of incorporation, agreements or applicable law may obligate us to indemnify our current and former directors, officers and employees with respect to certain liabilities, and we have been advancing legal fees and costs to many current and former directors, officers and employees in connection with the DOJ investigation, securities actions and certain other matters.
We continue to defend against the securities actions described below vigorously and are currently unable to provide any estimate as to the timing of the resolution of these actions. Any settlement of or judgment in one or more of these actions substantially in excess of our recorded reserves could have a significant impact on us, and we can give no assurance that we will have the resources available to pay any such judgment. The magnitude of any settlement or judgment resulting from these actions could materially and adversely affect our ability to meet our debt obligations and our financial condition, potentially impacting our credit ratings, our ability to access capital markets and our compliance with debt covenants. In addition, the magnitude of any such settlement or judgment may cause us to draw down significantly on our cash balances, which might force us to obtain additional financing or explore other methods to generate cash. Such methods could include issuing additional securities or selling assets.
On July 9, 2002, we were informed by the U.S. Attorneys Office for the District of Colorado of a criminal investigation of our business. We believe the U.S. Attorneys Office has investigated various matters that include transactions related to the various adjustments and restatements described in our 2002 Financial Statements, transactions between us and certain of our vendors and certain investments in the securities of those vendors by individuals associated with us, and certain prior disclosures made by us. We are continuing in our efforts to cooperate fully with the U.S. Attorneys Office in its investigation. However, we cannot predict the outcome of this investigation or the timing of its resolution.
Remaining Securities Actions
We are a defendant in the securities actions described below. Plaintiffs in these actions have variously alleged, among other things, that we violated federal and state securities laws, engaged in fraud, civil conspiracy
and negligent misrepresentation, and breached fiduciary duties owed to investors and current and former employees. Other defendants in one or more of these actions include current and former directors of Qwest, former officers and employees of Qwest, Arthur Andersen LLP, certain investment banks and others.
A putative class action is pending in the federal district court for the Southern District of New York against us, certain of our former executives who were also on the supervisory board of KPNQwest, N.V. (of which we were a major shareholder), and others. This lawsuit was initially filed on October 4, 2002. The current complaint alleges, on behalf of certain purchasers of KPNQwest securities, that, among other things, defendants engaged in a fraudulent scheme and deceptive course of business in order to inflate KPNQwests revenue and the value of KPNQwest securities. Plaintiffs seek compensatory damages and/or rescission as appropriate against defendants, as well as an award of plaintiffs attorneys fees and costs. On February 3, 2006, we, certain other defendants and the putative class representative in this action executed an agreement to settle the case against us and certain other defendants. Under the settlement agreement, we will pay $5.5 million in cash to the settlement fund no later than 30 days following preliminary court approval, and no later than 30 days following final approval by the court, we will issue shares of our stock to the settlement fund then valued at $5.5 million as additional consideration for the settlement. The settlement agreement would settle the individual claims of the putative class representative and the claims of the class he purports to represent against us and all defendants except Koninklijke KPN N.V. a/k/a Royal KPN N.V., Willem Ackermans, Eelco Blok, Joop Drechsel, Martin Pieters, and Rhett Williams. The settlement agreement is subject to a number of conditions and future contingencies. Among others, it (i) requires both preliminary and final court approval; (ii) provides us with the right to terminate the settlement if class members representing more than a specified amount of alleged securities losses elect to opt out of the settlement; (iii) provides us with the right to terminate the settlement if we do not receive adequate protections for claims relating to substantive liabilities of non-settling defendants; and (iv) is subject to review on appeal even if the district court were finally to approve it. Any lawsuits that may be brought by parties opting out of the settlement will be vigorously defended regardless of whether the settlement described herein is consummated. No parties admit wrongdoing as a part of the settlement agreement.
On October 31, 2002, Richard and Marcia Grand, co-trustees of the R.M. Grand Revocable Living Trust, dated January 25, 1991, filed a lawsuit in Arizona Superior Court which, as amended, alleges, among other things, that the defendants violated state and federal securities laws and breached their fiduciary duty in connection with investments by plaintiffs in securities of KPNQwest. We are a defendant in this lawsuit along with Qwest B.V. (one of our subsidiaries), Joseph Nacchio, our former Chairman and Chief Executive Officer, and John McMaster, the former President and Chief Executive Officer of KPNQwest. Plaintiffs claim to have lost approximately $10 million in their investments in KPNQwest. The court granted defendants motion for partial summary judgment with respect to a substantial portion of plaintiffs claims. The court entered judgment for defendants on those claims and dismissed the remaining claims without prejudice. We have entered into a
tolling agreement with plaintiffs that allows them to re-file these remaining claims following their appeal of the courts order granting summary judgment to defendants on a substantial portion of plaintiffs claims. Plaintiffs have filed such an appeal with the Arizona Court of Appeals.
On June 25, 2004, J.C. van Apeldoorn and E.T. Meijer, in their capacities as trustees in the Dutch bankruptcy proceeding for KPNQwest, filed a complaint in the federal district court for the District of New Jersey alleging violations of the Racketeer Influenced and Corrupt Organizations Act, and breach of fiduciary duty and mismanagement under Dutch law. We are a defendant in this lawsuit along with Joseph Nacchio, Robert S. Woodruff, our former Chief Financial Officer, and John McMaster. Plaintiffs allege, among other things, that defendants actions were a cause of the bankruptcy of KPNQwest and the bankruptcy deficit of KPNQwest was in excess of $3 billion. Plaintiffs seek compensatory, treble and punitive damages, as well as an award of plaintiffs attorneys fees and costs.
On June 17, 2005, Appaloosa Investment Limited Partnership I, Palomino Fund Ltd., and Appaloosa Management L.P. filed a complaint in the federal district court for the Southern District of New York against us, Joseph Nacchio, John McMaster and Koninklijke KPN N.V., or KPN. The complaint alleges that defendants violated federal securities laws in connection with the purchase by plaintiffs of certain KPNQwest debt securities. Plaintiffs seek compensatory damages, as well as an award of plaintiffs attorneys fees and costs.
Various former lenders to KPNQwest or their assignees, including Citibank, N.A., Deutsche Bank AG London and others, have notified us of their intent to file legal claims in connection with the origination of a credit facility and subsequent borrowings made by KPNQwest of approximately 300 million under that facility. They have indicated that we would be a defendant in this threatened lawsuit along with Joseph Nacchio, John McMaster, Drake Tempest, our former General Counsel, KPN and other former employees of Qwest, KPN or KPNQwest.
On August 23, 2005, the Dutch Shareholders Association (Vereniging van Effectenbezitters, or VEB) filed a petition for inquiry with the Enterprise Chamber of the Amsterdam Court of Appeals, located in the Netherlands, with regard to KPNQwest. VEB seeks an inquiry into the policies and course of business at KPNQwest that are alleged to have caused the bankruptcy of KPNQwest in May 2002, and an investigation into alleged mismanagement of KPNQwest by its executive management, supervisory board members, joint venture entities (us and KPN), and KPNQwests outside auditors and accountants.
Other than the putative class action in which we have entered into a proposed settlement (and for which we have recorded a reserve of $11 million in connection with the proposed settlement), we will continue to defend against the pending KPNQwest litigation matters vigorously and will likewise defend against any claims asserted by KPNQwests former lenders if litigation is filed.
On July 15, 2004, the New Mexico state regulatory commission opened a proceeding to investigate whether we are in compliance with or are likely to meet a commitment that we made in 2001 to invest in communications infrastructure in New Mexico through March 2006 pursuant to an Alternative Form of Regulation plan, or AFOR. The AFOR says, in part, that Qwest commits to devote a substantial budget to infrastructure investment, with the goal of achieving the purposes of this Plan. Specifically, Qwest will make capital expenditures of not less than $788 million over the term of this Plan. This level of investment is necessary to meet the commitments made in this Plan to increase Qwests investment and improve its service quality in New Mexico. Multiple parties filed comments in that proceeding and variously argued that we should be subject to a range of requirements including an escrow account for capital spending, new investment obligations, and customer credits or price reductions.
On April 14, 2005, the Commission issued its Final Order in connection with this investigation. In this Final Order, the Commission ruled that the evidence in the record indicates we will not be in compliance with the
investment commitment at the conclusion of the AFOR in March 2006, and if the current trend in our capital expenditures continues, there will be a shortfall of $200 million or more by the end of the AFOR. The Commission also concluded that we have an unconditional commitment to invest $788 million over the life of the AFOR. Finally, the Commission ruled that if we fail to satisfy this investment commitment, any shortfall must be credited or refunded to our New Mexico customers. The Commission also opened an enforcement and implementation docket to review our investments and consider the structure and size of any refunds or credits to be issued to customers. On May 12 and 13, 2005, we filed appeals in federal district court and in the New Mexico State Supreme Court, respectively, challenging the lawfulness of the Commissions Final Order. On May 31, 2005, the Commission issued an order, in response to a report we filed on May 20, 2005, designating a hearing examiner to conduct proceedings addressing whether customer credits and refunds should be imposed on us based on our investment levels as of June 30, 2005, and prior to the expiration of the AFOR in March 2006.
We have vigorously argued, among other things, that the underlying purposes of the investment commitment set forth in the AFOR have been met in that we have met all service quality and service deployment obligations under the AFOR; that, in light of this, we should not be held to a specific amount of investment; and that the Commission has failed to include all eligible investments in the calculation of how much we have actually invested. Nevertheless, we believe it is unlikely the Commission will reverse its determination that we have an unconditional obligation to invest $788 million. In addition, we have argued, and will continue to argue, that customer credits or refunds are an impermissible and illegal form of relief for the Commission to order in the event there is an investment shortfall. On January 30, 2006, Qwest filed with the New Mexico Commission an Offer of Settlement and to Revise AFOR. This Offer proposes to extend the time period for Qwest to complete $788 million in investments to three years following the approval of the Offer. Under the Offer, Qwest has included within the $788 million of total investments a proposal to invest $85 million in projects approved by the Commission. In an order dated February 7, 2006, the Commission rejected the Offer on technical grounds, ruling that it was improper as to form. In this order, the Commission also encouraged Qwest and the other parties to continue settlement negotiations.
We believe there is a substantial likelihood that the ultimate outcome of this matter will result in us having to make expenditures or payments beyond those we would otherwise make in the normal course of business. These expenditures or payments could take the form of one or more of the following: penalties, capital investment, basic service rate reductions and customer refunds or credits. At this time, however, we are not able to reasonably estimate the amount of these expenditures or payments and, accordingly, have not reserved any amount for such potential liability. Any final resolution of this matter could be material.
Several putative class actions relating to the installation of fiber optic cable in certain rights-of-way were filed against us on behalf of landowners on various dates and in various courts in California, Colorado, Georgia, Illinois, Indiana, Kansas, Mississippi, Missouri, North Carolina, Oregon, South Carolina, Tennessee and Texas. For the most part, the complaints challenge our right to install our fiber optic cable in railroad rights-of-way. Complaints in Colorado, Illinois and Texas, also challenge our right to install fiber optic cable in utility and pipeline rights-of-way. The complaints allege that the railroads, utilities and pipeline companies own a limited property right-of-way that did not include the right to permit us to install our fiber optic cable in the right-of-way without the Plaintiffs consent. Most actions (California, Colorado, Georgia, Kansas, Louisiana, Mississippi, Missouri, North Carolina, Oregon, South Carolina, Tennessee and Texas) purport to be brought on behalf of state-wide classes in the named plaintiffs respective states. Several actions purport to be brought on behalf of multi-state classes. The Illinois state court action purports to be on behalf of landowners in Illinois, Iowa, Kentucky, Michigan, Minnesota, Nebraska, Ohio and Wisconsin. The Illinois federal court action purports to be on behalf of landowners in Arkansas, California, Florida, Illinois, Indiana, Missouri, Nevada, New Mexico, Montana and Oregon. The Indiana action purports to be on behalf of a national class of landowners adjacent to railroad rights-of-way over which our network passes. The complaints seek damages on theories of trespass and unjust enrichment, as well as punitive damages.
The IRS proposed a tax adjustment for tax years 1994 through 1996. The principal issue involves the allocation of costs between long-term contracts with customers for the installation of conduit or fiber optic cable and additional conduit or fiber optic cable retained by us. The IRS disputes the allocation of the costs between us and third parties. Similar claims have been asserted against us with respect to the 1997 to 1998 and the 1998 to 2001 audit periods. The 1994-1996 claim is currently being litigated in the Tax Court, and we do not believe the IRS will be successful, although the ultimate outcome is uncertain. If we were to lose this issue for the tax years 1994 through 1998, we estimate that we would have to pay approximately $57 million in tax plus approximately $43 million in interest pursuant to tax sharing agreements with the Anschutz Company relating to those time periods.
In 2004, we recorded income tax expense of $158 million related to a change in the expected timing of deductions related to our tax strategy, referred to as the Contested Liability Acceleration Strategy, or CLAS, which we implemented in 2000. CLAS is a strategy that sets aside assets to provide for the satisfaction of asserted liabilities associated with litigation in a tax efficient manner. CLAS accelerated deductions for contested liabilities by placing assets for potential litigation liabilities out of the control of the company and into trusts managed by a third-party trustee. In 2004, we were formally notified by the IRS that it was contesting the CLAS tax strategy. Also in 2004 as a result of a series of notices on CLAS strategies issued by the IRS and the receipt of legal advice with respect thereto, we adjusted our accounting for CLAS as required by Statement of Financial Accounting Standards, or SFAS, No. 109, Accounting for Income Taxes, or SFAS No. 109. The change in expected timing of deductions caused an increase in our liability for uncertain tax positions and a corresponding increase in our net operating loss carry-forwards, or NOLs. Because we are not currently forecasting future taxable income sufficient to realize the benefits of this increase in our NOLs, we recorded an increase in our valuation allowance on deferred tax assets as required by SFAS No. 109. Additionally, in 2004 the IRS proposed a penalty of $37 million on this strategy. We believe that the imposition of a penalty is not appropriate as we acted in good faith in implementing this tax strategy in reliance on two contemporaneous tax opinions and adequately disclosed this transaction to the IRS in our initial and subsequent tax returns. We intend to vigorously defend our position on this and other tax matters.
We have other tax related matters pending against us, certain of which, in addition to CLAS, are before the Appeals Office of the IRS. We believe we have adequately provided for these matters.
Matters Resolved in the Fourth Quarter of 2005
Beginning in 2002, formal proceedings against us were initiated with the public utilities commissions in several states alleging, among other things, that we, in contravention of federal and state law, failed to file interconnection agreements with the state commissions and that we therefore allegedly discriminated against various CLECs. The complainants sought fines, penalties and/or carrier credits. Most of these cases were previously resolved. Two remaining state commission proceedings were resolved as follows:
Based upon newly-discovered evidence, on August 24, 2005, Qwest filed a motion requesting that the federal district court vacate the penalty based on our assertion that the underlying Minnesota Commission order is invalid. On November 30, 2005, the district court denied Qwests motion to vacate, and it denied Qwests request for reconsideration. Qwest also requested the Minnesota Commission to investigate the newly-discovered evidence that relates to the validity of orders issued in this and other Minnesota Commission proceedings, and on October 7, 2005, the Minnesota Commission opened an investigation into the matter. The outcome of this investigation could lead to action by the Minnesota Commission that ultimately results in a reduction of the $26 million penalty assessment.
On January 20, 2004, we filed a complaint in the District Court for the City and County of Denver against KMC Telecom LLC and several of its related parent or subsidiary companies (collectively referred to as KMC). Subsequently, we filed an amended complaint to name additional defendants, including General Electric Capital Corporation, or GECC, one of KMCs lenders, and GECC filed a complaint in intervention. We were seeking a declaration that a series of agreements with KMC and its lenders were not effective because conditions precedent were not satisfied and to recoup other damages and attorneys fees and costs. GECC and KMC had asserted counterclaims for declaratory judgment and anticipatory breach of contract. GECC and KMC sought a declaration that the relevant agreements are in effect and claimed monetary damages for anticipatory breach of the agreements and their attorneys fees and costs. In November 2005, we entered into a settlement agreement with KMC and GECC regarding this lawsuit and also various other disputes and obligations between the parties. Under the terms of the settlement, we paid $98 million in order to resolve the lawsuit and all other disputes and obligations between and among us, KMC and GECC. As a result of the settlement, we have severed our relationship with KMC in its entirety.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2005.
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market for Qwest Common Stock
The United States market for trading in our common stock is the New York Stock Exchange. As of February 1, 2006, our common stock was held by approximately 370,000 stockholders of record. The following table sets forth the high and low sales prices per share of our common stock for the periods indicated.
We did not pay any cash dividends on our common stock in 2005 or 2004. Some of our debt instruments contain restrictions on the amount of dividends we can pay (see Note 8Borrowings to our consolidated financial statements in Item 8 of this report). The most restrictive covenant currently is under the 2005 QSC Credit Facility, which is currently undrawn. The 2005 QSC Credit facility currently allows us to pay dividends up to $1.7 billion, and the $1.7 billion may be increased with cumulative net income and net proceeds from the issuance of common stock. In addition, like other companies that are incorporated in Delaware, we are also limited by Delaware law in the amount of dividends we can pay.
Recent Sales of Unregistered Securities
On October 6, 2005, we issued an aggregate of 33,626 additional shares of our common stock upon the exercise of warrants at an aggregate exercise price of $1,441. The warrants were issued by ICON CMT Corp. in 1997 to one of its consultants and were assumed by us in connection with our acquisition of ICON CMT Corp. in 1999. The shares were issued in reliance on the exemption from registration provided by Section 3(a)(9) of the Securities Act of 1933, as amended. No underwriters were involved, and no sales commission or other remuneration was paid in connection with the issuance.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with, and are qualified by reference to, the consolidated financial statements and notes thereto in Item 8 of this report and Managements Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this report. Certain prior year amounts have been reclassified to conform to current-year presentation.
2005. 2005 net loss includes a net loss of $ 462 million ($0.25 per basic and diluted share) relating to the early retirement of debt, a charge of $22 million ($0.01 per basic and diluted share) resulting from adoption of Financial Accounting Standards Board, or FASB, Interpretation, or FIN, No. 47, Accounting for Conditional Asset Retirement Obligations, or FIN 47, relating to accounting for conditional asset retirement obligations, a charge of $114 million ($0.06 per basic and diluted share) for realignment and severance related costs, which is included in our selling, general and administrative expenses; and a gain of $ 263 million ($0.14 per basic and diluted share) in connection with wireless asset sales of PCS licenses and related wireless network assets.
2004. 2004 net loss includes a charge of $550 million ($0.31 per basic and diluted share) for litigation related losses; a net charge of $211 million ($0.12 per basic and diluted share) for restructuring, realignment and severance related costs which is included in our selling, general and administrative expenses; a charge of $113 million ($0.06 per basic and diluted share) for an impairment of assets consisting primarily of excess network supplies, network facilities, payphone operations and abandoned long-term capacity routes and a benefit of approximately $50 million ($0.03 per basic and diluted share) relating to favorable customer bankruptcy settlements.
2003. 2003 net income includes a charge of $140 million ($0.08 per basic and diluted share) for an impairment of assets (primarily cell sites, switches, related tools and equipment inventory and certain
information technology systems supporting the wireless network), a net gain of $206 million ($0.12 per basic and diluted share) resulting from the adoption of SFAS No. 143, Accounting for Asset Retirement Obligations, or SFAS No. 143, relating to the reversal of net removal costs where there was not a legal removal obligation, a net charge of $241 million ($0.14 per basic and diluted share) resulting from the termination of services arrangements with Calpoint and another service provider, a net charge of $69 million ($0.04 per basic and diluted share) for restructuring charges, a net charge of $61 million ($0.04 per basic and diluted share) for litigation related losses, a net gain of $23 million ($0.01 per basic and diluted share) relating to the early retirement of debt and a net gain on sale of discontinued operations of $2.619 billion ($1.51 per basic and diluted share).
2002. 2002 net loss includes a charge of $22.800 billion ($13.55 per basic and diluted share) for a transitional impairment from the adoption of a change in accounting for goodwill and other intangible assets, charges aggregating $14.927 billion ($8.87 per basic and diluted share) for additional goodwill and asset impairments, a net charge of $112 million ($0.07 per basic and diluted share) for Merger-related, restructuring and other charges, a charge of $1.190 billion ($0.71 per basic and diluted share) for the losses and impairment of investment in KPNQwest, a gain of $1.122 billion ($0.67 per basic and diluted share) relating to the gain on the early retirement of debt and income from and gain on sale of discontinued operations of $1.950 billion ($1.16 per basic and diluted share).
2001. 2001 net loss includes charges aggregating $697 million ($0.42 per diluted share) for Merger-related, restructuring and other charges, a charge of $3.300 billion ($1.99 per basic and diluted share) for the losses and impairment of investment in KPNQwest, a charge of $136 million ($0.08 per basic and diluted share) for a depreciation adjustment on access lines returned to service, a charge of $163 million ($0.10 per basic and diluted share) for investment write-downs, a charge of $154 million ($0.09 per basic and diluted share) for asset impairments, a charge of $65 million ($0.04 per basic and diluted share) for the early retirement of debt and a gain of $31 million ($0.02 per basic and diluted share) for the sale of rural exchanges.
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Certain statements set forth below under this caption constitute forward-looking statements. See BusinessSpecial Note Regarding Forward-Looking Statements in Item 1 of this report for additional factors relating to such statements, and see Risk Factors in Item 1A of this report for a discussion of certain risk factors applicable to our business, financial condition and results of operations.
Business Overview and Presentation
We provide local telecommunications and related services, long-distance services and wireless, data and video services within our local service area, which consists of the 14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We also provide reliable, scalable and secure broadband data and voice (including long-distance) communications outside our local service area as well as globally.
We previously provided directory publishing services in our local service area. In November 2002, we sold our directory publishing business in seven of the 14 states in which we offered these services. In September 2003, we sold the directory publishing business in the remaining states. As a consequence, the results of operations of our directory publishing business are included in income from discontinued operations in our consolidated statements of operations.
Our analysis presented below is organized to provide the information we believe will be instructive for understanding the relevant trends going forward. However, this discussion should be read in conjunction with our consolidated financial statements in Item 8 of this report, including the notes thereto. Our operating revenue is generated from our wireline services, wireless services and other services segments. An overview of the segment results is provided in Note 15Segment Information to our consolidated financial statements in Item 8 of this report. Segment discussions reflect the way we currently report our segment results to our Chief Operating Decision Maker, or CODM, and include revenue results for each of our customer channels within the wireline services segment: business, mass markets and wholesale. In order to better serve the similar needs of our small business and consumer customers, in 2005 we combined these customers into a new channel, which we refer to as mass markets, and have reclassified our small business customers for all periods presented. Certain prior year revenue and expense amounts have been reclassified to conform to the current year presentations.
Our financial results continue to be impacted by several significant trends, which are described below:
While these trends are important to understanding and evaluating our financial results, the other transactions, events and trends discussed in Risk Factors in Item 1A of this report may also materially impact our business operations and financial results.
Results of Operations
We generate revenue from our wireline services, wireless services and other services. Depending on the products or services purchased, a customer may pay an up-front or monthly fee, a usage charge or a combination of these.
The following table summarizes our results of operations for the years ended 2005, 2004 and 2003:
nmpercentages greater than 200% and comparisons from positive to negative values or to zero values are considered not meaningful.
2005 COMPARED TO 2004
The following table compares our operating revenue by segment including the detail of customer channels within our wireline services segment:
Wireline Services Revenue
Local voice services. The decrease in local voice services revenue in our business and mass markets channels was primarily due to access line losses from competitive pressures including technology substitution, partially offset by an increase in Universal Service Fund, or USF, revenue due to long-distance revenue growth and USF rate increases. In our mass markets channel we have seen a slowing of access line losses, and this, combined with rate increases in this channel, has decreased our rate of revenue decline from 10% in 2004 to 4% in 2005. The decrease in our wholesale channel was primarily due to the sale of a large portion of our payphone business in August 2004 partially offset by UNE increases, including our non-tariff product. In addition, wholesale access lines decreased along with sales of UNEs and related operator and billing services to local competitors as an increasing percentage of competition in our local area is coming from facilities-based competition, including wireless and cable companies.
The following table shows our access lines by channel as of December 31, 2005 and 2004:
Long-distance services. The increase in mass markets long-distance services revenue was primarily due to (i) a 6% increase in in-region long-distance subscribers (adding 270,000 subscribers in 2005) (ii) increased minutes of use, (iii) increases in our monthly recurring charges, and (iv) increased participation in our unlimited plan. These increases were partially offset by out-of region declines in both mass markets and business. The wholesale revenue increase was driven by volume and domestic rate increases partially offset by decreased international volume and rates.
Access services. Access services revenue continues to be negatively affected by mass markets and business access line losses, as well as our increasing penetration into in-region long-distance (as we became a competitor to our access services customers). The decrease in total access services was partially offset by favorable settlements of customer billing disputes during 2005.
Data and Internet Services
The increase in business data and Internet services revenue was driven by the recognition of $70 million in revenue from a large government CPE and other data services arrangement and increased revenue related to WAN (including IQ and UPN) and Private Line services, partially offset by a decrease in Frame Relay revenue. We anticipate that the large government CPE and other data services arrangement will continue to positively impact our revenue growth, although to a lesser extent, for the next few quarters as this contract is completed.
The increase in mass markets data and Internet services revenue was primarily driven by a 43% increase in the number of high-speed Internet subscribers as we expanded our high-speed Internet service area to 77% of our local service area in 2005 from 67% in 2004. This growth came from continued expansion of service availability and increased penetration of high-speed Internet where service is available. We believe this growth was supported by our expanded marketing efforts.
The decline in our wholesale channel was due to the termination of our wholesale modem services product in April 2005 partially offset by increases in Frame Relay, Private Line and dedicated Internet access revenue.
Wireless Services Revenue
Wireless services revenue increased primarily due to increased price plan and airtime rates for new subscribers resulting in higher average revenue per subscriber. Although the average number of subscribers for 2005 declined as compared to 2004, total subscribers as of December 31, 2005 increased 2% from December 31, 2004.
2004 COMPARED TO 2003
The following table compares our operating revenue by segment including the detail of customer channels within our wireline services segment:
Wireline Services Revenue
Local voice services. The decrease in our local voice services revenue was primarily due to access line losses from competitive pressures including technology substitution and was also impacted by our customers migrating to our package offerings, which generally offer lower pricing than our stand-alone products. In particular, in 2004 and 2003, a significant portion of the losses of our mass markets and business access lines was attributable to the CLECs use of UNE-P and unbundled local loops to deliver voice services. These losses were partially offset by corresponding increases in our wholesale access lines (where UNEs are reflected) in our wholesale channel. However, the regulated price structure of UNEs applied downward pressure on our revenue.
The following table shows our access lines by channel as of December 31, 2004 and 2003:
Long-distance services. The decrease in local voice services revenue was partially offset by an increase in long distance services revenue. In January 2003, we began to receive regulatory approval to offer long-distance service in each state within our 14-state region. In the fourth quarter of 2003, we received regulatory approval for the last of our 14 in-region states. As we received regulatory approval in each of the states, we began to increase the marketing and promotion of InterLATA long-distance service to our customers, resulting in growth of in-region long-distance services revenue. In total, 2.4 million and 2.2 million long distance subscribers were added in our 14-state region in 2004 and 2003, respectively. In contrast, out-of-region long-distance mass markets and business revenue declined due to continuing competitive pressures, including pricing pressures. Wholesale long-distance revenue increased due to increased international and domestic long-distance call volume, partially offset by lower rates.
Access services. The decrease in access services was primarily due to lower volumes resulting from our re-entry into in-region long distance (as we became a competitor to our access services customers) and access line losses.
Data and Internet Services
Data and Internet services revenue increased due to increases in our high-speed Internet, Internet hosting and VPN offerings, and broadband services continued to be expanded geographically to make our high-speed Internet service available to more customers. The number of mass markets high-speed Internet subscribers grew by 62%, and we expanded our high-speed Internet service area to 67% of our local service area in 2004; however, the impact of increases in mass markets high-speed Internet subscribers and related revenue was offset in part by decreases in wholesale data and Internet services revenue.
Wireless Services Revenue
The decrease in our wireless revenue is primarily attributable to a net loss of 116,000, or 13% of subscribers in 2004. A portion of the 2004 loss of subscribers occurred in connection with the migration, completed in 2005, of our customers to a third-party network and tightened credit policies.
This section should be read in conjunction with our business trends discussed above.
2005 COMPARED TO 2004
The following table provides further detail regarding our operating expenses:
nmpercentages greater than 200% and comparisons from positive to negative values or to zero values are considered not meaningful.
Cost of Sales
Cost of sales includes employee-related costs, such as salaries, wages and benefits directly attributable to products or services, network expenses, facility costs and other non-employee related costs such as real estate, USF charges, call termination fees, materials and supplies, contracted engineering services, computer system support and the cost of CPE sold.
Cost of sales as a percentage of revenue decreased from 43% in 2004 to 42% in 2005 primarily due to decreased facility and employee-related costs as described below.
Facility costs decreased largely due to cost savings primarily from network optimization efforts including the renegotiation, termination or settlement of service arrangements. These benefits were partially offset by approximately $220 million in increases associated with reselling wireless through a third party as opposed to operating and maintaining our own wireless network and higher long distance volumes.
Employee-related costs decreased primarily due to a 5% employee reduction from our prior year restructuring plans as well as a continued focus on containing our employee-related costs and productivity improvements.
Other non-employee related costs increased primarily due to non-recurring costs associated with the large government CPE and other data services arrangement described above. The remaining fluctuation is primarily due to increased call termination fees related primarily to a favorable settlement in 2004, and USF rate increases, offset by decreased equipment costs related to our wireless and high-speed Internet products.
Selling, General and Administrative
Selling, general and administrative, or SG&A, expenses include employee-related costs such as salaries, wages and benefits not directly attributable to products or services, severance related costs, sales commissions, bad debt charges and other non-employee related costs such as property taxes, real estate costs, advertising, professional service fees and computer systems support.
SG&A expenses as a percentage of revenue decreased from 36% in 2004 to 30% in 2005 primarily due to $550 million of reserves recorded in 2004 related to litigation matters and employee-related costs primarily due to prior year restructuring as described below.
Our property and other taxes decreased primarily due to favorable property tax settlements in 2005 in excess of property tax settlements in 2004.
Bad debt expense decreased primarily due to the continued trend of improved wireline collections resulting in reduced days sales outstanding, partially offset by favorable bad debt settlements in 2004.
Restructuring, realignment and severance related costs decreased due to a charge of $128 million in the second quarter of 2004 resulting from a planned workforce reduction. Employee-related costs decreased primarily due to employee reductions from our restructuring efforts, normal attrition and productivity improvements.
Other non-employee related costs decreased for the year ended December 31, 2005 primarily due to $550 million of reserves recorded in 2004 related to litigation matters and reductions in legal and other costs in 2005. This decrease was partially offset by increased marketing and advertising costs.
Pension and post-retirement benefits. We sponsor noncontributory defined benefit pension plans covering substantially all of our employees. Our post-retirement benefit plans for current and certain future retirees include healthcare and life insurance coverage.
Our 2005 pension and post-retirement benefit expense of $236 million increased from the 2004 expense of $188 million. Increases in expense were due to a reduction in the expected return on assets of $78 million related primarily to the five year smoothing convention used for recognizing gains and losses on the pension plan assets, completion of the amortization of $63 million for the transition asset in the pension plan in 2004, and recognition of $42 million in higher actuarial losses. Offsetting decreases in expense were due to $15 million in lower service costs due to reduced headcount and fewer eligible participants, reduced interest costs of $111 million due to lower discount rates, changes in participant demographics and assumption changes, and $9 million due to plan design changes affecting prior service costs.
At December 31, 2005 and 2004 the net unrecognized actuarial loss related to the pension and post-retirement benefit plans decreased by $634 million and $210 million, respectively. Differences between expected and actual rates of return on assets, discount rates applied to the pension and post-retirement plan obligations, expected benefit from Medicare Part D reimbursements and healthcare claims experience are the primary components of the net unrecognized actuarial (gain) loss.
The difference created between the expected return on assets and the actual net earnings on the assets is deferred at the end of the year and classified as an unrecognized net actuarial (gain) loss. Lower than expected earnings create losses and higher than expected earnings create gains. Similarly, the difference between the discount rate at the beginning of the year and the discount rate at the end of the year is deferred at the end of the year and classified as an unrecognized net actuarial (gain) loss. Lower than expected discount rates create losses and higher than expected discount rates create gains. Unrecognized net actuarial losses are similar to deferred costs and are amortized to expense over 9 to 11 years based on the average remaining service period of the employees expected to receive benefits in accordance with pension and post-retirement benefit accounting rules. The impact of recognizing amortization of the net actuarial losses increased the net cost included in current
earnings by $136 million, $94 million and $101 million for the years ended December 31, 2005, 2004 and 2003, respectively. Net unrecognized actuarial losses increase the prepaid pension asset and lower the post-retirement liability recorded in the financial statements while net unrecognized actuarial gains decrease the prepaid pension asset and increase the post-retirement liability. A significant decrease in net unrecognized actuarial losses is more likely to occur as a result of changes in the debt and equity markets than through amortization.
For additional information on our pension and post-retirement plans see Note 11Employee Benefits to our consolidated financial statements in Item 8 of this report.
Operating Expenses by Segment
Segment expenses include employee-related costs, facility costs, network expenses and other non-employee related costs such as customer support, collections and marketing. We manage indirect administrative services costs such as finance, information technology, real estate and legal centrally; consequently, these costs are included in the other services segment. We evaluate depreciation, amortization, interest expense, interest income, and other income (expense) on a total company basis. As a result, these charges are not assigned to any segment. Similarly, we do not include impairment charges in the segment results. Our CODM regularly reviews the results of operations at a segment level to evaluate the performance of each segment and allocate resources based on segment income.
Wireline Services Segment Expenses
The following table provides further financial detail regarding our wireline services segment for the years ended December 31, 2005 and 2004:
Wireline services operating expenses decreased primarily due to decreased facility costs achieved through network optimization initiatives and the renegotiation, termination or settlement of services arrangements, savings in employee-related costs as a result of our restructuring and reduced restructuring and severance related costs, offset by the cost associated with the large data CPE arrangement mentioned above.
Wireless Services Segment Expenses
The following table provides detail regarding our wireless services segment for the years ended December 31, 2005 and 2004:
Wireless services operating expenses increased primarily due to facility costs associated with our customers who previously received their services on our network and whose services we now provide through a third-party. As a result of this transition, beginning in the third quarter of 2004, we realized savings in depreciation and other non-employee related costs such as real estate costs, network costs and professional fees. In addition, other non-employee related costs decreased due to decreased marketing and advertising directly attributable to our wireless product. We expect our facility costs as a percentage of wireless revenue to remain relatively constant subject to certain volume discounts as volumes increase. Wireless bad debt increased due to a change in the application of our credit policy and a decline in collections.
Other Services Segment Expenses
Other services expenses include corporate expenses for services such as finance, information technology, legal, marketing services and human resources, which we centrally manage and are not assigned to the wireline or wireless services segments. The following table sets forth additional expense information to provide greater detail as to the composition of the other services segment for the years ended December 31, 2005 and 2004:
The decrease in other services expense was primarily driven by $550 million in litigation reserves recorded in 2004, partially offset by increased marketing expenses. Restructuring, realignment and severance related costs decreased due to significant restructuring charges recorded in 2004, which exceeded 2005 employee realignment costs incurred as we continued to right-size our workforce.
2004 COMPARED TO 2003
The following table provides further detail regarding our operating expenses:
Cost of Sales
Cost of sales includes employee-related costs, such as salaries, wages and benefits directly attributable to products or services, network expenses, facility costs and other non-employee related costs such as real estate, USF charges, call termination fees, materials and supplies, contracted engineering services, computer system support and the cost of CPE sold.
Cost of sales as a percentage of revenue decreased from 45% in 2003 to 43% in 2004 due to decreased facility and employee-related costs as described below.
Facility costs decreased primarily due to the renegotiation, termination or settlement of service arrangements and network optimization initiatives. These activities resulted in savings during the period of over $675 million, of which approximately $400 million were caused by one-time termination charges in 2003. Additionally, we experienced a decrease of approximately $260 million as a result of reduction in our reliance on third party facility providers. These additional decreases were more than offset by (i) international, mass markets and wholesale long-distance volume increases, (ii) facility costs associated with the increase in long-distance revenue in our local service area and (iii) commencement of usage of a third-party wireless network as we migrated our wireless customers.
The decrease in network costs was primarily due to improved maintenance and right-of-way costs related to our out-of-region network.
The decrease in employee related costs was primarily due to employee reductions from our restructuring efforts, normal attrition and productivity improvements.
Other non-employee related costs increased primarily due to increased equipment costs for high-speed Internet modems as a result of subscriber growth and for wireless handsets as a result of the transition of our customers to a third-party wireless network, and increased voice/data CPE costs. The higher equipment costs were partially offset by favorable call termination fees, reduced materials purchases and external commissions.
Selling, General and Administrative
SG&A expenses include employee-related costs such as salaries, wages and benefits not directly attributable to products or services, severance related costs, sales commissions, bad debt charges and other non-employee related costs such as property taxes, real estate costs, advertising, professional service fees and computer systems support.
SG&A expenses as a percentage of revenue increased from 33% in 2003 to 36% in 2004 primarily due to increased litigation expenses and restructuring, realignment and severance costs as described below.
The decrease in property and other taxes was primarily due to reduced property values as a result of our impairments and favorable settlements in 2004.
The decrease in bad debt expense was primarily due to a favorable settlement of approximately $50 million in the second quarter 2004 from customers emerging from bankruptcy, and improved credit policies and collection processes.
The increase in restructuring, realignment and severance related costs was primarily due to our 2004 restructuring plan pursuant to which we reduced 4,000 employees in certain job functions, including information technology, network construction, customer installations, sales and back-office areas, in response to continued declines in revenue and our plans for improved operational efficiencies. $28 million of the increase in restructuring costs was due to changes in sublease projections for idle real estate properties.
The decrease in employee related expenses was due to employee reductions related to the above mentioned restructuring plans.
The increase in other non-employee related costs was primarily attributable to the $550 million of charges recorded in 2004 and the $100 million recorded in 2003 for litigation matters that are further discussed in Legal Proceedings in Item 3 of this report.
Pension and post-retirement benefits. Our 2004 pension and post-retirement benefit expense of $188 million decreased from the 2003 expense of $209 million. Decreases in expense were due to recognition of $7 million in lower actuarial losses partially due to the recognition of the Medicare Part D benefit, $10 million in lower service costs due to reduced headcount and fewer covered participants, a reduction in interest costs of $69 million due to lower discount rates and a reduction of $32 million due to plan design changes affecting prior service costs. These decreases are partially offset by increases in expense due to a reduction in the expected return on assets of $89 million related primarily due to the reduction in the expected long-term rate of return on plan assets from 9.00% to 8.50% and lower amortization of $8 million due to the completion of the amortization for the transition asset in the pension plan in 2004.
Operating Expenses by Segment
Segment expenses include employee-related costs, facility costs, network expenses and other non-employee related costs such as customer support, collections and marketing. We manage indirect administrative services costs such as finance, information technology, real estate and legal centrally; consequently, these costs are assigned to the other services segment. We evaluate depreciation, amortization, interest expense, interest income, and other income (expense) on a total company basis. As a result, these charges are not included in any segment.
Similarly, we do not include impairment charges in the segment results. Our CODM regularly reviews the results of operations at a segment level to evaluate the performance of each segment and allocate capital resources based on segment income.
Wireline Services Segment Expenses
The following table provides further financial detail regarding our wireline services segment for the years ended December 31, 2004 and 2003:
The decrease in wireline operating expenses was primarily due to the reductions in facility costs discussed above.
Wireless Services Segment Expenses
The following table provides detail regarding our wireless services segment for the years ended December 31, 2004 and 2003:
nmpercentages greater than 200% and comparisons from positive to negative values or to zero values are considered not meaningful.
Wireless operating expenses increased, primarily due to facility and network costs associated with the costs of transitioning wireless services to a third-party provider. These facility and network costs included usage and roaming costs associated with our use of the third-party providers network and development costs associated with the migration of our customers to the third-party providers network. Other non-employee related costs increased due to additional marketing and advertising costs as we aggressively marketed our new wireless products.
Other Services Segment Expenses
The following table sets forth additional expense information to provide greater detail as to the composition of the other services segment for the years ended December 31, 2004 and 2003:
The increase in other services expense is primarily due to increased other non-employee related costs attributable to the $550 million of charges recorded in 2004 compared to the $100 million recorded in 2003 for litigation matters that are further discussed in more detail above in Operating expenses2004 compared to 2003selling, general and administrative expenses and an increase in professional fees related to the outsourcing of our information technology services. This increase was partially offset by lower hardware, software and maintenance costs resulting from such outsourcing.
Partially offsetting the increase in other non-employee related costs were lower employee-related costs, attributable to decreases in salaries and wages and overtime related to our agreement to outsource certain information technology services and lower property and other taxes due to changes in property tax estimates and a one-time $28 million expense reduction from a successful property tax appeal.
Non-Segment Operating Expenses
The decreases in depreciation were primarily the result of reduced capital expenditures beginning in 2002 as well as asset impairment charges, recorded in 2004 and 2003, which resulted in decreases in the depreciable basis of our fixed assets. The level of depreciation in all three years is lower than in previous years due to our impairment of assets in 2002.
Capitalized Software and Other Intangible Assets Amortization
The increase in amortization expense from 2003 to 2004 was attributable to the increase in total capitalized software. The decrease from 2004 to 2005 was primarily due to the completion of amortization for a number of intangible assets.
Asset Impairment Charges
In conjunction with our efforts to sell certain assets during 2004, we determined that the carrying amounts of those assets were in excess of our expected sales proceeds. This, in addition to the abandonment of various leased long-term network capacity routes, resulted in an asset impairment charge of $113 million in 2004.
The 2003 asset impairment charges of $230 million were due to the anticipated decrease in usage of our wireless network following the transition of our customers onto a third-party network.
For more information on our asset impairment charges, please see Note 4Property, Plant and Equipment to our consolidated financial statements in Item 8 of this report.
Other Consolidated Results
The following table provides further detail regarding other expensenet, income tax benefit (expense) and cumulative effect of changes in accounting principlesnet of taxes:
Other expensenet includes interest expense, net of capitalized interest; investment write-downs; gains and losses on the sales of investments and fixed assets; gains and losses on early retirement of debt; declines in market values of warrants to purchase securities in other entities; and our share of the investees income or losses for investments accounted for under the equity method of accounting.
Interest expensenet. Interest expense decreased from 2004 to 2005 primarily due to the expensing of unamortized debt issue costs associated with the early termination of a previous credit facility in 2004 and from 2003 to 2004 primarily due to the significant pay-down of debt in 2003 using cash proceeds from the sale of our directory business. We expect that our interest expense will decline by approximately $300 million in 2006 as a result of our debt restructuring activity. See Note 8Borrowings to our consolidated financial statements in Item 8 of this report for further information.
Loss(gain) on early retirement of debt-net. The 2005 loss on early retirement of debt was primarily due to the payment of premiums associated with the extinguishment of certain of our higher coupon debt. The gain in 2003 was primarily attributable to a $44 million gain due to the exchange of debt for shares of our common stock in 2003.
Other incomenet. The decrease from 2004 to 2005 was primarily due to $80 million in gains in 2004 from the settlement of customers emerging from bankruptcy and termination of indefeasible rights of use, or IRU, agreements, offset in part by a $50 million increase in interest income from higher interest rates and an increase in cash and investment balances. The decrease from 2003 to 2004 was primarily due to gains related to the early termination of services contracts and IRU agreements, which were $20 million higher in 2003.
Gain on sale of assets. The gain on the sale of assets in 2005 was due to the sale of all of our PCS licenses and substantially all of our related wireless network assets.
Income Tax Benefit
Our continuing operations effective tax benefit (expense) rate was 0.4%, (5.1)%, and 28.3% in 2005, 2004 and 2003, respectively. The increase from 2004 to 2005 was primarily due to expenses recognized during 2004 for uncertain tax positions. The decrease in our income tax benefit from 2003 to 2004 was primarily due to a net charge to tax expense of $88 million in 2004, which was primarily due to the $158 million increase to our asset valuation allowance for CLAS. This increase was offset primarily by a reduction in our liability for other uncertain tax positions. This and other related tax matters could require significant cash outlays if they are not successfully defended. See Note 14Income Taxes to our consolidated financial statements in Item 8 of this report for further information.
Cumulative Effect of Changes in Accounting PrinciplesNet of Tax
In 2005, we recognized a charge of $22 million from the cumulative effect of adopting FIN No. 47, Accounting for Conditional Asset Retirement Obligations. In 2003, we recognized a gain of $206 million (net of $131 million of taxes) from the cumulative effect of adopting SFAS No. 143. See Note 2Summary of Significant Accounting Policies to our consolidated financial statements in Item 8 of this report for further information.
Liquidity and Capital Resources
Our working capital deficit, or the amount by which our current liabilities exceed our current assets, was $1,071 million and $68 million as of December 31, 2005 and 2004, respectively. The increase in our working capital deficit was primarily caused by our use of cash to fund our tender offer for high coupon debt in the quarter ended December 31, 2005, which more than offset the working capital generated by our operations net of capital expenditures.
We believe that our cash on hand together with our short-term investments, our currently undrawn revolver and our cash flows from operations should be sufficient to meet our cash needs through the next twelve months. However, if we become subject to significant judgments, settlements and/or tax payments, as further discussed in Legal Proceedings in Item 3 of this report, we could be required to make significant payments that we may not have the resources to make. The magnitude of any settlements or judgments resulting from these actions could materially and adversely affect our ability to meet our debt obligations and our financial condition, potentially impacting our credit ratings, our ability to access capital markets and our compliance with debt covenants. In addition, the magnitude of any settlements or judgments may cause us to draw down significantly on our cash balances, which might force us to obtain additional financing or explore other methods to generate cash. Such methods could include issuing additional securities or selling assets.
To the extent that our EBITDA (as defined in our debt covenants) is reduced by cash judgments, settlements and/or tax payments, our debt to consolidated EBITDA ratios under certain debt agreements will be adversely affected. This could reduce our liquidity and flexibility due to potential restrictions on drawing on our line of credit and potential restrictions on incurring additional debt under certain provisions of our debt agreements.
The 2005 QSC Credit Facility contains various limitations, including a restriction on using any proceeds from the facility to pay settlements or judgments relating to the investigation and securities actions discussed in Legal Proceedings in Item 3 of this report.
The wireline services segment provides over 95% of our total operating revenue with the balance attributed to our wireless services and other services segments and the wireline services segment also provides all of the consolidated cash flows from operations. Cash flows used in operations of our wireless services segment are not expected to be significant in the near term. Cash flows used in operations of our other services segment are significant; however, we expect that the cash flows provided by the wireline services segment will be sufficient to fund these operations in the near term.
We expect that our 2006 capital expenditures will be slightly higher than our 2005 levels, with the majority being used in our wireline services segment.
During the year ended December 31, 2005, we completed several transactions to improve our near-term financial position, including registered exchange offers, cash tender offers and consent solicitations with respect to our high coupon debt, issuances of new debt and convertible notes and debt-for-equity exchanges. For a more detailed description of these activities, see Note 8Borrowings to our consolidated financial statements in Item 8 of this report.
In November 2005, QCII sold $1.265 billion aggregate principal amount of 3.50% Convertible Senior Notes due 2025 under a universal shelf registration statement filed with the SEC in August 2005. Due to changes in the federal securities laws effective in December 2005, we will not issue any additional securities under that registration statement. In December 2005, we filed a new universal shelf registration statement, under which we may issue up to $1.235 billion of securities in one or more offerings. Our ability and willingness to issue securities pursuant to this registration statement will depend on market conditions at the time of any such desired offering.
As a result of the various debt offerings, exchanges and payments in 2005, we expect that our interest expense will decline by approximately $300 million in 2006.
We have historically operated with a working capital deficit as a result of our highly leveraged position, and it is likely that we will operate with a working capital deficit in the future. We believe that cash provided by operations and our currently undrawn revolver, combined with our current cash position and continued access to capital markets to refinance our current portion of debt, should allow us to meet our cash requirements for the foreseeable future.
We may periodically need to obtain financing in order to meet our debt obligations as they come due. We may also need to obtain additional financing or investigate other methods to generate cash (such as further cost reductions or the sale of assets) if revenue and cash provided by operations decline, if economic conditions weaken, if competitive pressures increase or if we become subject to significant judgments, settlements and/or tax payments as further discussed in Legal Proceedings in Item 3 of this report. In the event of an adverse outcome in one or more of these matters, we could be required to make significant payments that we do not have the resources to make. The magnitude of any settlements or judgments resulting from these actions could materially and adversely affect our ability to meet our debt obligations and our financial condition, potentially impacting our credit ratings, our ability to access capital markets and our compliance with debt covenants. In addition, the magnitude of any settlements or judgments may cause us to draw down significantly on our cash balances, which might force us to obtain additional financing or explore other methods to generate cash. Such methods could include issuing additional securities or selling assets.
The 2005 QSC Credit Facility makes available to us $850 million of additional credit subject to certain restrictions as described below, and is currently undrawn. This facility has a cross payment default provision, and
this facility and certain other debt issues also have cross acceleration provisions. When present, such provisions could have a greater impact on liquidity than might otherwise arise from a default or acceleration of a single debt instrument. These provisions generally provide that a cross default under these debt instruments could occur if:
Upon such a cross default, the creditors of a material amount of our debt may elect to declare that a default has occurred under their debt instruments and to accelerate the principal amounts due such creditors. Cross acceleration provisions are similar to cross default provisions, but permit a default in a second debt instrument to be declared only if in addition to a default occurring under the first debt instrument, the indebtedness due under the first debt instrument is actually accelerated. In addition, the 2005 QSC Credit Facility contains various limitations, including a restriction on using any proceeds from the facility to pay settlements or judgments relating to the investigation and securities actions discussed in Legal Proceedings in Item 3 of this report.
Payment Obligations and Contingencies
The following table summarizes our future contractual cash obligations as of December 31, 2005:
Employee Benefit Plans. We offer pension, non-qualified, post-retirement healthcare and life insurance benefits to certain current and future retirees, some of which are due under contractual agreements. Pension and certain occupational post-retirement benefits are paid through trusts and therefore are not included in this table as we are not able to reliably estimate future required contributions to the trusts, if any. As of December 31, 2005, our qualified defined benefit pension plan was fully funded. As of December 31, 2005, we had a liability recorded on our balance sheet of $3.459 billion for non-qualified pension, post-retirement healthcare and life insurance and other post-employment benefit obligations. The liability is impacted by various actuarial assumptions and will differ from the sum of the future value of actuarially estimated payments. See further discussion of our benefit plans in Note 11Employee Benefits to our consolidated financial statements in Item 8 of this report.
Off-Balance Sheet Arrangements
In 2004, we identified two relationships that may be subject to consolidation by us under the accounting guidance in FIN No. 46 (revised December 2003), Consolidation of Variable Interest Entities, or FIN 46R. Both relationships are with entities that provide or provided Internet port access and services to their customers. In November 2005, we entered into a settlement agreement with one of the entities, which terminated any potential variable interests and any consolidation requirements under FIN 46R. We do not currently have sufficient information about the other entity to complete our analysis under FIN 46R, even though until this entity ceased doing business we continuously requested such information. Unless further information becomes available to us about this entity, which we believe is unlikely because the entity has ceased doing business, we are unable to come to any conclusion regarding consolidation under FIN 46R. We previously recorded a liability and charge associated with our relationship with the second entity, and as a result, we believe that our exposure to loss, excluding interest accretion, has been reflected in our consolidated financial statements.
Other than this entity and the operating leases described above, we have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity, or market or credit risk support, and we do not engage in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financial statements.
Letters of Credit
We maintain letter of credit arrangements with various financial institutions for up to $147 million. At December 31, 2005, we had outstanding letters of credit of approximately $144 million.
The following table summarizes the decrease in our cash and cash equivalents for the years ended December 31, 2005, 2004 and 2003:
nmpercentages greater than 200% and comparisons between positive and negative values or to zero values are considered not meaningful.
Our primary source of funds is cash generated from operating activities. During 2005 cash from operating activities improved as income increased due to our continued efforts to reduce costs and maintain or grow revenue. Changes in operating assets and liabilities caused a use of funds in 2005 due in large part to payments made on our contracts with KMC and our second and final payment of $125 million related to our 2004 settlement with the SEC. These uses were offset by additional improvements in working capital management from credit, collections and payment initiatives. In 2004, changes in operating assets and liabilities caused a source of funds largely due to a legal reserve of $550 million and tax reserves, reduced by our first payment of $125 million related to the above-mentioned settlement with the SEC. Cash provided by operating activities decreased from 2003 to 2004 as large settlement, tax and restructuring payments were offset by improvements in our working capital accounts.
Cash used for investing activities decreased in 2005 primarily as a result of liquidating short-term investments in order to pay down debt and reduced capital expenditure levels. We believe that our current level of capital expenditures will sustain our business at existing levels and support our anticipated core growth requirements in areas such as high-speed Internet, long-distance and VoIP products.
Cash used for financing activities increased from 2004 to 2005 primarily due to debt repayments and associated early retirement of debt costs, and decreased from 2003 to 2004 primarily due to the payment of debt in 2003 with proceeds from the sale of our directory publishing business.
At December 31, 2005, we were in compliance with all provisions or covenants of our borrowings. See Note 8Borrowings to our consolidated financial statements in Item 8 of this report for more information on our 2005 and historical financing activities as well as additional information regarding the covenants of our existing debt instruments. We paid no dividends in 2005.
The table below summarizes our long-term debt ratings at December 31, 2005 and 2004:
NR = Not rated
* = QCII notes have various ratings
On October 20, 2005, S&P raised its ratings on QC to BB and assigned a BB rating to the 2005 QSC Credit Facility. On November 1, 2005, Moodys raised its ratings on Qwest and its affiliates as reflected in the table above. In addition, Moodys assigned a B1 rating to the 2005 QSC Credit Facility. On November 15, 2005, Fitch raised its ratings on Qwest and its affiliates as reflected in the table above. At the same time, Fitch also assigned a BB+ rating to the 2005 QSC Credit Facility.
With respect to Moodys, a Ba rating is judged to have speculative elements, meaning that the future of the issuer cannot be considered to be well-assured. Often the protection of interest and principal payments may be very moderate, and thereby not well safeguarded during both good and bad times. The 1,2,3 modifiers show relative standing within the major categories, 1 being the highest, or best, modifier in terms of credit quality.
With respect to S&P, any rating below BBB indicates that the security is speculative in nature. A BB rating indicates that the issuer currently has the capacity to meet its financial commitment on the obligation; however, it faces major ongoing uncertainties or exposure to adverse business, financial or economic conditions, which could lead to the obligors inadequate capacity to meet its financial commitment on the obligation. An obligation rated B is more vulnerable to nonpayment than obligations rated BB, but the obligor currently has capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligors capacity or willingness to meet its financial commitment on the obligation. The plus and minus symbols show relative standing within the major categories.
With respect to Fitch, any rating below BBB is considered speculative in nature. A BB rating indicates that there is a possibility of credit risk developing, particularly as the result of adverse economic change over time; however, business or financial alternatives may be available to allow financial commitments to be met. A B rating indicates that significant credit risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is contingent upon a sustained, favorable business and economic environment. The plus and minus symbols show relative standing within major categories.
Debt ratings by the various rating agencies reflect each agencys opinion of the ability of the issuers to repay debt obligations as they come due. In general, lower ratings result in higher borrowing costs and/or impaired ability to borrow. A security rating is not a recommendation to buy, sell, or hold securities and may be subject to revision or withdrawal at any time by the assigning rating organization.
Given our current credit ratings, as noted above, our ability to raise additional capital under acceptable terms and conditions may be negatively impacted.
Critical Accounting Policies and Estimates
We have identified the policies and estimates below as critical to our business operations and the understanding of our results of operations, either past or present. For a detailed discussion on the application of
these and other significant accounting policies, see the notes to our consolidated financial statements in Item 8 of this report. These policies and estimates are considered critical because they either had a material impact or they have the potential to have a material impact on our financial statements, and because they require significant judgments, assumptions or estimates. Note that our preparation of this annual report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. We believe that the estimates, judgments and assumptions made when accounting for items and matters such as future usage under long-term contracts, customer retention patterns, collectibility of accounts receivable, expected economic duration of assets to be depreciated or amortized, asset valuations, internal labor capitalization rates, recoverability of assets, rates of return on assets held for employee benefits, timing and amounts of future employee benefit payments, uncertain tax positions, reserves and other provisions and contingencies are reasonable, based on information available at the time they are made. However, there can be no assurance that actual results will not differ from those estimates.
Loss Contingencies and Litigation Reserves
We are involved in several material legal proceedings, as described in more detail in Legal Proceedings in Item 3 of this report. We assess potential losses in relation to these and other pending or threatened legal and tax matters. For matters not related to income taxes, if a loss is considered probable and the amount can be reasonably estimated, we recognize an expense for the estimated loss. If a loss is considered possible and the amount can be reasonably estimated, we disclose it if material. For income tax related matters, we record a liability computed at the statutory income tax rate if we determine that (i) we do not believe that we are more likely than not to prevail on an uncertainty related to the timing of recognition for an item, or (ii) we do not believe that it is probable that we will prevail and the uncertainty is not related to the timing of recognition. The overall tax liability also considers the anticipated utilization of any applicable tax credits and net operating losses. To the extent these estimates are more or less than the actual liability resulting from the resolution of such matters, our earnings will be increased or decreased accordingly and if the differences are material, our consolidated financial statements could be materially impacted.
Revenue Recognition and Related Reserves
Revenue from services is recognized when the services are provided. Up-front fees received, primarily activation fees and installation charges, as well as the associated customer acquisition costs, are deferred and recognized over the expected life of the product, generally one to five years. Payments received in advance are deferred until the service is provided. Customer arrangements that include both equipment and services are evaluated to determine whether the elements are separable based on objective evidence. If the elements are deemed separable, total consideration is allocated to each element based on the relative fair values of the separate elements and the revenue associated with each element is recognized as earned. If the elements are not deemed separable, total consideration is deferred and recognized ratably over the longer of the contractual period or the expected customer relationship period. We believe that the accounting estimates related to estimated lives and to the assessment of whether bundled elements are separable are critical accounting estimates because: (i) they require management to make assumptions about how long we will retain customers; (ii) the assessment of whether bundled elements are separable is subjective; (iii) the impact of changes in actual retention periods versus these estimates on the revenue amounts reported in our consolidated statements of operations could be material; and (iv) the assessment of whether bundled elements are separable may result in revenue being reported in different periods than significant portions of the related costs.
As the telecommunications market experiences greater competition and customers shift from traditional land based telephony services to wireless and Internet-based services, our estimated customer relationship period could decrease and we will accelerate the recognition of deferred revenue and related costs over a shorter estimated customer relationship period.
Restructuring and Realignments
Periodically, we commit to exit certain business activities, eliminate office or facility locations and/or reduce our number of employees. The amount we record for such a charge depends upon various assumptions, including future severance payments, sublease income, length of time on market for abandoned rented facilities and contractual termination costs. Such estimates are inherently judgmental and may change materially based upon actual experience. The estimate of future losses on sublease income and disposal activity generally involves the most significant judgment. Due to the estimates and judgments involved in the application of each of these accounting policies, changes in our plans and these estimates and market conditions could materially impact our financial condition or results of operations.
Economic Lives of Assets to be Depreciated or Amortized
Due to rapid changes in technology and the competitive environment, selecting the estimated economic life of telecommunications plant, equipment and software requires a significant amount of judgment. We regularly review data on utilization of equipment, asset retirements and salvage values to determine adjustments to our depreciation rates. The effect of a one year increase or decrease in the estimated useful lives of our property, plant and equipment would have been decreased depreciation of approximately $370 million or increased depreciation of approximately $520 million, respectively. The effect of a one year increase or decrease in the estimated useful lives of our intangible assets with finite lives would have been decreased amortization of approximately $80 million or increased amortization of approximately $130 million, respectively.
Pension and Post-Retirement Benefits
Pension and post-retirement healthcare and life insurance benefits attributed to employees service during the year, as well as interest on projected benefit obligations, are accrued currently. Prior service costs and credits resulting from changes in plan benefits are amortized over the average remaining service period of the employees expected to receive benefits or over the term of the collective bargaining agreement, as applicable. Pension and post-retirement costs are recognized over the period in which the employee renders service and becomes eligible to receive benefits as determined using the projected unit credit method.
In computing the pension and post-retirement healthcare and life insurance benefit costs, we must make numerous assumptions about such things as discount rates, expected rate of return on plan assets, employee mortality and turnover, salary and wage increases, expected future cost increases, healthcare claims experience and negotiated caps on reimbursable costs. These items generally have the most significant impact on the level of cost: the discount rate, the expected rate of return on plan assets and the terms of our post-retirement plan benefits covered by collective bargaining agreements as negotiated with our employees unions.
Annually, we set our discount rate primarily based upon the yields on high-quality fixed-income investments available at the measurement date and expected to be available during the period to maturity of the pension and other post-retirement benefits. In making this determination, we use a simple average of four specific indices of high quality corporate bond yields that would generate the necessary cash flows to pay our projected benefits when due.
The expected rate of return on plan assets is the long-term rate of return we expect to earn on the plans assets. The rate of return is determined by the investment composition of the plan assets and the long-term risk and return forecast for each asset category. The forecasts for each asset class are generated using historical information as well as an analysis of current and expected market conditions. The expected risk and return characteristics for each asset class are reviewed annually and revised, as necessary, to reflect changes in the financial markets.
The estimate of the accumulated benefit obligation (ABO) for our occupational (union) post-retirement plan benefits is based on the terms of our written benefit plan as negotiated with our employees unions. In making this determination we consider the exchange of benefits between us and our employees that occurs as part of the negotiations.
We have a noncontributory qualified defined benefit pension plan, or the pension plan, for substantially all management and occupational (union) employees. Our post-retirement benefit plans for certain current and future retirees include healthcare and life insurance benefits. To compute the expected return on pension and post-retirement benefit plan assets, we apply an expected rate of return to the market-related asset value of the pension plan and to the fair value of post-retirement plan assets. The market-related asset value is a computed value that recognizes changes in fair value of pension plan equity assets over a period of time, not to exceed five years. The five year weighted average gains and losses related to the equity assets are added to the fair value of bonds and other assets at year-end to arrive at the market-related asset value. In accordance with SFAS No. 87, Employers Accounting for Pensions, we elected to recognize actual returns on our pension plan assets ratably over a five year period when computing our market-related value of pension plan assets. This method has the effect of reducing the impact on expense from annual market volatility that may be experienced from year to year.
Changes in any of the assumptions we made in computing the pension and post-retirement healthcare and life insurance benefit costs could have a material impact on various components that comprise these expenses. Factors to be considered include the strength or weakness of the investment markets, changes in the composition of the employee base, fluctuations in interest rates, significant employee hiring or downsizings, medical cost trends and changes in our collective bargaining agreements. Changes in any of these factors could impact cost of sales and SG&A in the consolidated statement of operations as well as the value of the asset or liability on our consolidated balance sheet. If our assumed expected rate of return of 8.5% for 2005 were 100 basis points lower, the impact would have been to increase the pension and post-retirement expense by $97 million. If our assumed discount rate of 5.75% for 2005 were 100 basis points lower, the impact would have been to increase the net expense by $77 million. If the caps on reimbursement of post-retirement health costs for certain plan participants that are effective January 1, 2009, were not substantive, the impact would have been to increase our ABO approximately $2.3 billion.
The pension plan ABO represents the actuarial present value of benefits based on employee service and compensation as of a certain date and does not include an assumption about future compensation levels. If the ABO exceeds plan assets and at least this amount has not been accrued, an additional minimum liability must be recognized. Annually, we evaluate the funded status of our pension plan to determine whether any additional minimum liability is required to be recognized.
Recoverability of Long-lived Assets
Due to our ongoing losses, we periodically perform evaluations of the recoverability of the carrying value of our long-lived assets using gross undiscounted cash flow projections. These evaluations require identification of the lowest level of identifiable, largely independent, cash flows for purposes of grouping assets and liabilities subject to review. The cash flow projections include long-term forecasts of revenue growth, gross margins and capital expenditures. All of these items require significant judgment and assumptions. We believe our estimates are reasonable, based on information available at the time they were made. However, if our estimates of our future cash flows had been different, we may have concluded that some of our long-lived assets were not recoverable, which would likely have caused us to record a material impairment charge. Also, if our future cash flows are significantly lower than our projections we may determine at some future date that some of our long-lived assets are not recoverable.
Impairments of Long-lived Assets
Pursuant to the 2003 services agreement with a third-party provider that allows us to resell wireless services, our wireless customers who were serviced through our proprietary wireless network were transitioned onto the third-party providers network. Due to the anticipated decrease in usage of our own wireless network following the transition of our customers onto this network, in the third quarter of 2003 we performed an evaluation of the recoverability of the carrying value of our long-lived wireless network assets.
We compared gross undiscounted cash flow projections to the carrying value of the long-lived wireless network assets and determined that certain asset groups were not expected to be recovered through future projected cash flows. For those asset groups that were not recoverable, we then estimated the fair value using estimates of market prices for similar assets. Cell sites, switches, related tools and equipment inventory and certain information technology systems that support the wireless network were determined to be impaired by $230 million.
Estimating the fair value of the asset groups involved significant judgment and a variety of assumptions. Comparable market data was obtained by reviewing recent sales of similar asset types. The price allocated to these assets in our subsequent agreement to sell the assets to Verizon indicated that the ultimate proceeds from the sale of the assets differed from our estimate by an immaterial amount.
Asset Retirement Obligations
We have network assets located in leased properties such as equipment rooms, central offices, and wireless sites. For certain of these leases, we are legally obligated to remove our equipment when the lease expires. As required by SFAS No. 143, we record a liability for the estimated current fair value of the costs associated with these removal obligations. We estimate our removal liabilities using historical cost information, industry factors, and current engineering estimates. We then estimate the present value of these costs by discounting the future expected cash payout to current fair value based on our incremental borrowing rate. To the extent there are material differences between our estimated and actual removal costs and our estimated and actual discount rates, we could be required to adjust our recorded liabilities at that time. These estimates were critical factors in determining the net income impact of $206 million upon the adoption of SFAS No. 143 in 2003.
Recently Adopted Accounting Pronouncements and Cumulative Effect of Adoption
In December 2005, we adopted FIN 47, which is an interpretation of SFAS No. 143 and requires us to recognize asset retirement obligations that are conditional on a future event, such as the obligation to safely dispose of asbestos when a building is demolished or under certain circumstances, renovated. Upon adoption of FIN 47, we determined that we have conditional asset retirement obligations to properly dispose of or encapsulate asbestos in several of our buildings and to close fuel storage tanks and dispose of other potentially hazardous materials. We recorded a cumulative effect of a change in accounting principle charge upon adoption of FIN 47 of $22 million (liability of $26 million net of an asset of $4 million) in 2005. Had FIN 47 been adopted prior to 2003, our liabilities associated with asset retirement obligations would have increased by $25 million both at December 31, 2004 and 2003. Had we adopted FIN 47 prior to 2003, our operating results for the years ending December 31, 2005, 2004 and 2003 would not have changed materially.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Non-Monetary Assets, or SFAS No. 153, which we adopted in July 2005. Prior to the adoption of SFAS No. 153, we were required to measure the value of certain assets exchanged in non-monetary transactions by using the net book value of the asset relinquished. Under SFAS No. 153, we now measure assets exchanged at fair value, as long as the transaction has commercial substance and the fair value of the assets exchanged is determinable within reasonable limits. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The adoption of SFAS No. 153 has not had a material effect on our financial position or results of operations for the year ended December 31, 2005.
We adopted the provisions of FIN 46R in the first quarter of 2004. FIN 46R requires an evaluation of three additional criteria to determine if consolidation is required. These criteria are: (i) whether the entity is a variable interest entity; (ii) whether the company holds a variable interest in the entity; and (iii) whether the company is the primary beneficiary of the entity. If all three of these criteria are met, consolidation is required.
Upon adoption of FIN 46R, we identified two relationships that may be subject to consolidation by us under the provisions of FIN 46R. Both relationships are with groups of entities that provide Internet port access and
services to their customers. The first relationship was with entities owned by KMC Telecom Holdings, Inc. As discussed in Legal ProceedingsMatters Resolved in the Fourth Quarter of 2005 in Item 3 of this report, in November 2005 we entered into a settlement agreement with KMC and one of its lenders to resolve all outstanding disputes and obligations between and among us, KMC and the lender. As a result of the settlement, we have severed our relationship with KMC in its entirety and terminated any potential variable interests and any consolidation requirements under FIN 46R.
We previously recorded a liability and charge associated with our relationship with the second entity. We do not currently have sufficient information about this entity to complete our analysis under FIN 46R, even though until this entity ceased doing business we had continuously requested such information. Unless further information becomes available to us about this entity, which we believe is unlikely because the entity has ceased doing business, we are unable to come to any conclusion regarding consolidation under FIN 46R. As a result of previously recording a liability and charge associated with this relationship, we believe that our exposure to loss, excluding interest accretion, has been reflected in our financial statements.
In December 2003, the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the Medicare Act) became law in the United States. The Medicare Act introduces a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree healthcare benefit plans that provide a benefit that is at least actuarially equivalent to the Medicare benefit. We adopted the provisions of FASB Staff Position No. 106-2 (FSP No. 106-2), Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. Accounting for the government subsidy provided under the Act reduced our accumulated post-retirement benefit obligation by $235 million. The Medicare Act reduced the prescription drug expense component of our 2005 and 2004 post-retirement benefit expenses by $38 million and $33 million, respectively. During 2005, the Center for Medicare and Medicaid Services issued and clarified rules for implementing the Medicare Act. We have revised our actuarial estimate of the federal subsidy and using our December 31, 2005 measurement date, the total reduction in our ABO was $510 million. This reduction was recorded as an unrecognized actuarial gain which will be amortized to expense. The issuance and clarification of the rules for implementing the Medicare Act during 2005 are expected to further reduce our prescription benefit cost in 2006. See Note 11Employee Benefits to our consolidated financial statements in Item 8 of this report.
Recently Issued Accounting Pronouncements
In May 2005, the FASB, as part of an effort to conform to international accounting standards, issued SFAS No. 154, Accounting Changes and Error Corrections, or SFAS No. 154, which was effective for us beginning on January 1, 2006. SFAS No. 154 requires that all voluntary changes in accounting principles are retrospectively applied to prior financial statements as if that principle had always been used, unless it is impracticable to do so. When it is impracticable to calculate the effects on all prior periods, SFAS No. 154 requires that the new principle be applied to the earliest period practicable. Currently, we do not anticipate any voluntary changes in accounting principles that, upon the adoption of SFAS No. 154, would have a material effect on our financial position or results of operations.
In April 2005, the SEC delayed the effective date of SFAS No. 123R, Share Based Payments, or SFAS No. 123R. SFAS No. 123R was effective for us as of the interim reporting period beginning January 1, 2006. SFAS No. 123R requires that compensation cost relating to share-based payment transactions be recognized in the financial statements based on the fair value of the equity or liability instruments issued. SFAS No. 123R covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. We do not anticipate that the adoption of SFAS No. 123R will have a material impact on our financial position or results of operations. However, depending on valuation factors such as the price of our common stock, if we grant stock-based awards at similar volume to what was granted in prior years, then the application of SFAS No. 123R could have a material impact on our results of operations in future periods.
We are exposed to market risks arising from changes in interest rates. The objective of our interest rate risk management program is to manage the level and volatility of our interest expense. We may employ derivative financial instruments to manage our interest rate risk exposure. We may also employ financial derivatives to hedge foreign currency exposures associated with particular debt.
Approximately $2.0 billion of floating-rate debt was exposed to changes in interest rates as of December 31, 2005 and December 31, 2004. This exposure is linked to LIBOR. A hypothetical increase of 100 basis points in LIBOR would have increased annual pre-tax interest expense by $20 million in 2005. As of December 31, 2005 and December 31, 2004, we had approximately $0.5 billion and $0.6 billion, respectively, of long-term fixed rate debt obligations maturing in the subsequent 12 months. We are exposed to changes in interest rates at any time that we choose to refinance this debt. A hypothetical increase of 100 or 200 basis points in the interest rates on any refinancing of the current portion of long-term debt would not have a material effect on our earnings.
As of December 31, 2005, we had $737 million invested in money market instruments and $60 million invested in auction rate securities. As interest rates change, so will the interest income derived from these instruments. Assuming that these investment balances were to remain constant, a hypothetical increase of 100 basis points in money market rates would be immaterial.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information under the caption Risk Management in Managements Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this report is incorporated herein by reference.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Qwest Communications International Inc.:
We have audited the accompanying consolidated balance sheets of Qwest Communications International Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders deficit, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits 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 audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Qwest Communications International Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
As discussed in note 2 to the accompanying consolidated financial statements, effective December 31, 2005, the Company adopted FASB Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations. Also, as discussed in note 2, effective January 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Qwest Communications International Inc.s internal control over financial reporting as of December 31, 2005, 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 16, 2006 expressed an unqualified opinion on managements assessment of, and the effective operation of, internal control over financial reporting.
February 16, 2006
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED BALANCE SHEETS