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Qwest Communications International 10-Q 2006 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended March 31, 2006
or
For the transition period from to
Commission File No. 001-15577
Qwest Communications International Inc. (Exact name of registrant as specified in its charter)
(303) 992-1400 (Registrant’s telephone number, including area code)
N/A (Former name, former address and former fiscal year, if changed since last report)
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 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):
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 April 30, 2006, 1,885,989,398 shares of common stock were outstanding.
Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
FORM 10-Q
TABLE OF CONTENTS
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Table of ContentsGLOSSARY 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.
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Table of Contents
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ITEM 1. FINANCIAL STATEMENTS
QWEST COMMUNICATIONS INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
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, and references in this report to “QCII” refer to Qwest Communications International Inc. on an unconsolidated, stand-alone basis.
Note 1: Basis of Presentation
These condensed consolidated interim financial statements are unaudited and are prepared in accordance with the instructions for Form 10-Q. In compliance with those instructions, certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted.
In the opinion of management, these statements include all the adjustments necessary to fairly present our condensed consolidated results of operations, financial position and cash flows as of March 31, 2006 and for all periods presented. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in our annual report on Form 10-K for the year ended December 31, 2005 (the “2005 Form 10-K”). The condensed consolidated results of operations and the condensed consolidated statement of cash flows for the three month period ended March 31, 2006 are not necessarily indicative of the results or cash flows expected for the full year.
Use of estimates
Our condensed consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions made when accounting for items and matters such as long-term contracts, customer retention patterns, allowance for bad debts, depreciation, amortization, asset valuations, internal labor capitalization rates, recoverability of assets, impairment assessments, employee benefits, taxes, reserves and other provisions and contingencies are reasonable, based on information available at the time they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the condensed consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We also assess potential losses in relation to threatened or pending 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. In instances where we have the potential to recover a portion of such a loss from a third party, we make a separate assessment of recoverability and reduce the estimated loss if recovery is also deemed probable. 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. Actual results could differ from these estimates. See Note 8—Commitments and Contingencies.
Certain prior period balances have been reclassified to conform to the current presentation.
Depreciation and amortization
Property, plant and equipment are shown net of depreciation on our condensed consolidated balance sheets. As of March 31, 2006 and December 31, 2005, accumulated depreciation was $30.8 billion and $30.4 billion, respectively.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Capitalized software and other intangible assets are shown net of amortization on our condensed consolidated balance sheets. Accumulated amortization was $1.4 billion and $1.3 billion as of March 31, 2006 and December 31, 2005, respectively.
Earnings per share
Basic earnings per share excludes dilution and is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if outstanding stock options are exercised and convertible debt is converted. The following is a reconciliation of the number of shares used in the basic and diluted earnings per share computations:
Options to purchase 42 million and 103 million shares of our common stock were outstanding during the three months ended March 31, 2006 and 2005, respectively, but have been excluded from the computation of diluted earnings per share because the strike prices of the options exceeded the average price of our common stock during those periods. Options to purchase another 6 million shares of our common stock that were outstanding at March 31, 2006 have also been excluded because the impact would have been antidilutive.
Recently adopted accounting pronouncements
In May 2005, the Financial Accounting Standards Board (“FASB”), as part of an effort to conform to international accounting standards, issued Statement of Financial Accounting Standards (“SFAS”) No. 154, “Accounting Changes and Error Corrections” (“SFAS No. 154”), which was effective for us beginning on January 1, 2006. SFAS No. 154 requires that all voluntary changes in accounting principles be 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. The adoption of SFAS No. 154 has not had a material effect on our financial position or results of operations.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payments” (“SFAS No. 123(R)”), which revises SFAS No. 123, “Accounting for Stock-Based Compensation.” See Note 2 for additional information on this recently adopted accounting pronouncement.
Note 2: Stock-Based Compensation
Adoption of SFAS No. 123(R)
Effective January 1, 2006, we adopted SFAS No. 123(R). Prior to 2006, we accounted for stock awards granted to employees under the intrinsic-value recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). Under the intrinsic-value method, no compensation expense was recognized for options granted to employees when the strike price of those options equals or exceeds the value of the underlying security on the measurement date. Under APB No. 25, stock-based compensation expense was generally limited to the excess of the stock price on the measurement date over the exercise price, if any, and was recorded as deferred compensation and amortized over the service period during which the stock option award vested. However, SFAS No. 123(R) requires that compensation expense be measured using estimates of the fair value of all stock-based awards.
We are applying the “modified prospective method” for recognizing the expense over the remaining vesting period for awards that were outstanding but unvested at January 1, 2006. Under the modified prospective method, we have not adjusted the financial statements for periods ending prior to December 31, 2005. Under the modified prospective method, the adoption of SFAS No. 123(R) applies to new awards and to awards modified, repurchased, or cancelled after December 31, 2005, as well as to the unvested portion of awards outstanding as of January 1, 2006.
SFAS No. 123(R) also requires us to estimate forfeitures in calculating the expense related to stock-based compensation (estimated at 40% for 2006 grants).
Compensation cost arising from stock-based awards is recognized as expense using the straight-line method over the vesting period. As of March 31, 2006, there was $67 million of total unrecognized compensation cost related to unvested stock-based awards, which we expect to recognize over remaining weighted average vesting terms of 3.0 years. For the three months ended March 31, 2006, our total stock-based compensation expense was $6 million, which includes $4 million of compensation expense for stock options and for stock issued under our Employee Stock Purchase Plan that would not have been recorded as expense under APB No. 25. We have not recorded any income tax benefit related to stock-based compensation in either of the three-month periods ended March 31, 2006 and 2005.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
The following table illustrates the effect on net income and earnings per share for the three months ended March 31, 2005 as if our stock-based compensation had been determined based on the fair value at the grant dates:
Stock Options
On June 23, 1997, Qwest adopted the Equity Incentive Plan. This plan was most recently amended and restated on October 4, 2000 and permits the grant of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock, stock units and other stock grants. The maximum number of shares of our common stock that may be issued under the Equity Incentive Plan at any time pursuant to awards is equal to 10% of the aggregate number of our common shares issued and outstanding reduced by the aggregate number of options and other awards then outstanding under the Equity Incentive Plan or otherwise. Issued and outstanding shares are determined as of the close of trading on the New York Stock Exchange on the preceding trading day. Since our merger with U S WEST, Inc., all option grants have been issued from this plan. As of December 31, 2005, the maximum number of shares of our common stock available for issuance under the Equity Incentive Plan was 187 million, with 137 million shares underlying outstanding options and 50 million shares available for issuance pursuant to new awards.
The Compensation and Human Resources Committee of our Board, or its delegate, approves the exercise price for each option. Stock options generally have an exercise price that is at least equal to the fair market value of the common stock on the date the stock option is granted, subject to certain restrictions. Stock option awards generally vest in equal increments over the vesting period of the granted option (generally three to five years). Unless otherwise provided by the Compensation and Human Resources Committee, our Equity Incentive Plan provides that, on a “change in control,” all awards granted under the Equity Incentive Plan will vest immediately. Options that we granted to our employees from June 1999 to September 2002 typically provide for accelerated vesting if the optionee is terminated without cause following a change in control. Since September 2002, options that we grant to our executive officers (vice president level and above) typically provide for accelerated vesting and an extended exercise period upon a change of control and options that we grant to all other employees typically provide for accelerated vesting if the optionee is terminated without cause following a change in control. Options granted subsequent to 2002 have ten-year terms.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Summarized below is the activity of our stock option plans for the three months ended March 31, 2006:
The options to purchase 131.7 million shares of Qwest common stock that were outstanding at March 31, 2006 had remaining contractual terms with a weighted average of 6.0 years. The aggregate intrinsic value for those outstanding options that were in the money was $210 million at March 31, 2006. Of those outstanding options to purchase shares of Qwest common stock, 115.5 million were exercisable at March 31, 2006 and had a weighted-average exercise price of $13.43 and remaining contractual terms with a weighted average of 5.6 years. These options, which were both exercisable and in the money, had an aggregate intrinsic value of $181 million.
Except for option awards with market-based vesting conditions, we use the Black-Scholes model to estimate the fair value of new stock option grants and establish such fair value at the date of grant. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Additionally, all option valuation models require the input of highly subjective assumptions including the expected life of the options and the expected stock price volatility. Because our employee stock options have characteristics significantly different from traded options, and changes in the input assumptions can materially affect the fair value estimate, estimates of the fair value of our stock option awards are subjective. Following are the weighted-average assumptions used and the resulting fair value estimates of options granted in the three months ended March 31, 2006 and 2005 excluding the market-based vesting condition awards described below:
We believe that the two most significant assumptions used in our estimates of fair value are the expected option life and the expected volatility, both of which we estimate based on historical information. During the three months ended March 31, 2006 and 2005, options to purchase 11.3 million and 0.3 million shares were exercised with aggregate intrinsic values totaling $24.4 million and $0.4 million, respectively.
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Restricted Stock
During the three months ended March 31, 2006, 5.8 million shares of restricted stock were granted under the Equity Incentive Plan. Based on prior grants, compensation expense of $2 million was recognized for restricted stock grants in the three months ended March 31, 2005.
Except for restricted stock awards with market-based vesting conditions, we use the closing price of our common stock on the date of the award as the fair value for restricted stock awards. Excluding the market-based vesting condition awards described below, the weighted average estimate of fair value for restricted stock awards granted during the three months ended March 31, 2006 was $6.15 per share. A summary of the status of unvested shares of restricted stock as of and during the three months ended March 31, 2006 is as follows:
Employee Stock Purchase Plan
We have an Employee Stock Purchase Plan (“ESPP”) under which we are authorized to issue 27 million shares of our common stock to eligible employees. Under the terms of the ESPP, eligible employees may authorize payroll deductions of up to 15% of their base compensation, as defined, to purchase our common stock at a price of 85% of the fair market value of our common stock on the last trading day of the month in which our common stock is purchased. In the three months ended March 31, 2006, approximately 465,000 shares were purchased under this plan at a weighted-average purchase price of $5.46 per share. During the three months ended March 31, 2006, we recognized compensation expense of approximately $450,000 for the difference between the employees’ purchase price and the fair market value of the stock.
Market-Based Vesting Condition Awards
On February 16, 2006, we granted non-qualified option awards to purchase a total of 3,851,000 shares of our common stock at an exercise price of $6.15 and restricted stock awards totaling 2,407,000 shares of our common stock. These awards include vesting provisions that are tied to the future market value of our common stock, therefore we do not believe our standard valuation models accurately estimate the fair value of these awards. We valued these awards using Monte-Carlo simulations and estimate that the grant date fair value of each option was $3.99 per option and the grant date fair value of each share of restricted stock was $5.07 per share. These estimates were based on the following assumptions:
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
We believe the most significant assumption used in our estimate of fair value is the expected volatility, which we estimated based on historical information.
We had not granted market-based vesting condition awards prior to February 16, 2006, and all such awards granted on that date were still outstanding as of March 31, 2006.
Note 3: Sale of Property and Equipment
In the first quarter of 2005, we closed the sale of our personal communications services, or PCS, licenses and substantially all of our related wireless network assets in our local service area (including cell sites and wireless network infrastructure, site leases, and associated network equipment). We received $418 million for these assets and recorded a gain of $257 million from this sale and dispositions of other wireless assets.
Note 4: Borrowings
As of March 31, 2006 and December 31, 2005, our borrowings, net of discounts and premiums, consisted of the following:
Borrowings classified as current are due and payable within twelve months from March 31, 2006. The balance of our $1.265 billion 3.50% Convertible Senior Notes due 2025 is classified as a long-term borrowing as of March 31, 2006 and December 31, 2005 because specified, market-based conversion requirements were not met as of such dates. For example, if our common stock has a closing price above $7.08 per share for twenty or more trading days during certain periods of thirty consecutive trading days, these notes would become available for conversion, and as a result all outstanding notes would be reclassified as a current obligation.
Note 5: Restructuring Charges
During 2004 and previous years, as part of our ongoing effort to evaluate our operating costs, we established restructuring programs, which included workforce reductions, consolidation of excess facilities, and restructuring of certain business functions. The restructuring reserve balances are included in our condensed consolidated balance sheets in accrued expenses and other current liabilities for the current portion and other long-term liabilities for the long-term portion. The charges and reversals are included in our condensed consolidated statements of operations in selling, general and administrative expense. As of March 31, 2006 and December 31,
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
2005, our restructuring reserve was $423 million and $428 million, respectively. The amount included as current liabilities was $47 million and $62 million, respectively, and the long-term portion was $376 million and $366 million, respectively. In the quarter ended March 31, 2006, $11 million in restructuring provisions was added to the reserve and $15 million of the reserve was utilized.
As of March 31, 2006, substantially all of the planned employee reductions associated with the 2004 and prior restructuring plans had been completed. The majority of the remaining restructuring reserve is for real estate exit costs, which we expect to utilize over the remaining terms of the leases.
Note 6: Employee Benefits
The components of the pension, non-qualified pension and post-retirement benefit expense are as follows:
The pension, non-qualified pension and post-retirement benefit expense is allocated between cost of sales and selling, general and administrative expense in our condensed consolidated statements of operations. The measurement date used to determine pension, non-qualified pension and other post-retirement healthcare and life insurance benefit measurements for the plans is December 31.
Note 7: Segment Information
Our three segments are (1) wireline services, (2) wireless services and (3) other services. Our chief operating decision maker (“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 as defined below.
Segment income consists of each segment’s revenue and direct expenses. Segment revenue is based on the types of products and services offered as described below. Segment expenses include employee-related costs, facility costs, network expenses and other non-employee related costs such as customer support, collections and telephone marketing. We manage indirect administrative services costs such as finance, information technology, real estate, marketing and advertising, human resources 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.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Our wireline services segment uses our network to provide voice services and data and Internet services to mass markets, business and wholesale customers. Our wireline services include:
We offer wireless services and equipment to residential and business customers, providing them the ability to use the same telephone number for their wireless phone as for their home or business phone. By utilizing a third-party network, we sell wireless services, including access to its nationwide PCS wireless network, to mass markets and business customers primarily in the states within our local service area.
Our other services revenue is predominantly derived from the sublease of some of our real estate, such as space in our office buildings, warehouses and other properties. Our other services segment expenses include unallocated corporate expenses for functions such as finance, information technology, real estate, legal, marketing and advertising services and human resources, which we centrally manage.
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.
Other than as already described herein, the accounting principles used are the same as those used in our condensed consolidated financial statements. The revenue shown below for each segment is derived from transactions with external customers. Substantially all of our assets are in our wireline and other segments.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Segment information for the three months ended March 31, 2006 and 2005 is summarized in the following table:
The following table reconciles segment income to net income for the three months ended March 31, 2006 and 2005:
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Table of ContentsQWEST COMMUNICATIONS INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
Set forth below is revenue information for the three months ended March 31, 2006 and 2005 for revenue derived from external customers for our products and services:
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.
We do not have any single customer that provides more than ten percent of the total of our revenue derived from external customers.
Note 8: Commitments and Contingencies
Throughout this note, 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 deposited in an escrow account 30 days after preliminary approval of the proposed settlement by the
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
federal district court in Colorado, $100 million of which would be so deposited 30 days after final approval of the settlement by the court, and $200 million of which would be so deposited 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 in the consolidated securities action will settle the individual claims of the class representatives and the claims of the class they represent against us and all defendants 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. No parties admit any wrongdoing as part of the proposed settlement.
The proposed settlement agreement is subject to a number of conditions and future contingencies. Among others, it (i) requires 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. We believe that the contingency relating to the distribution of funds paid by us in connection with our settlement with the Securities and Exchange Commission, or SEC, was satisfied on February 28, 2006, when the federal district court in Colorado entered an order approving the request of the SEC for authority to distribute, in accordance with the terms of that order the payments made by us and by certain of our former employees in connection with the settlements entered into between the SEC and us and the SEC and those former employees.
A number of parties, including large pension funds, have requested exclusion from the proposed settlement of the consolidated securities action. As noted below under “Remaining Securities Actions—Opt-Outs with Previously-Filed Lawsuits,” seven parties that had previously filed individual suits against us have requested exclusion from the proposed settlement, and as noted below under “Remaining Securities Actions—Opt-Outs with Recently-Filed Lawsuits,” some of the parties that have more recently requested exclusion from the proposed settlement have also asserted claims against us. We will vigorously defend against such claims regardless of whether the proposed settlement of the consolidated securities action is consummated.
Settlement of Consolidated ERISA Action
Seven putative class actions purportedly brought on behalf of all participants and beneficiaries of the Qwest Savings and Investment Plan and predecessor plans, or the Plan, from March 7, 1999 until January 12, 2004 have been consolidated into a consolidated action in federal district court in Colorado. Other defendants in this action include current and former directors of Qwest, former officers and employees of Qwest and Deutsche Bank. These suits also purport to seek relief on behalf of the Plan. The first of these actions was filed in March 2002. Plaintiffs assert breach of fiduciary duty claims against us and others under the Employee Retirement Income Security Act of 1974, as amended, alleging, among other things, various improprieties in managing holdings of our stock in the Plan. Plaintiffs seek damages, equitable and declaratory relief, along with attorneys’ fees and costs and restitution. Counsel for plaintiffs indicated that the putative class would seek billions of dollars of damages.
On April 26, 2006, we, the other defendants, and the putative class representatives entered into a Stipulation of Settlement that, if implemented, will settle the consolidated ERISA action. Under the proposed settlement
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agreement, we would pay a total of $33 million in cash no later than 90 days after preliminary approval of the proposed settlement by the federal district court in Colorado. Deutsche Bank would pay a total of $4.5 million in cash to settle the claims against it. No parties admit any wrongdoing as part of the proposed settlement. If the proposed settlement is approved by the court, we will receive certain insurance proceeds as a contribution by individual defendants to this settlement, which will offset $10 million of our $33 million payment. In addition to the $33 million cash settlement, we have also agreed to pay, subject to certain contingencies, the amount (if any) by which the Plan’s recovery from the settlement of the consolidated securities action is less than $20 million. If approved by the district court, the proposed settlement will settle and release the claims of the class against us and all defendants in the consolidated ERISA action. The proposed settlement, which is subject to preliminary and final approval by the district court, is also subject to review on appeal if the district court were finally to approve it.
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 for the minimum estimated amount of loss we believe is probable with respect to the remaining securities actions described below as well as any additional actions that may be brought by parties that, as described below under “Additional Opt-Out Parties,” have more recently opted out of the proposed settlement of the consolidated securities action. We have recorded our estimate of the minimum liability for 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. 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 continue to defend against the remaining 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 (or any additional actions that may be brought by parties that, as described below under “Additional Opt-Out Parties,” have more recently opted out of the proposed settlement of the consolidated securities action) 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.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) FOR THE THREE MONTHS ENDED MARCH 31, 2006 (UNAUDITED)
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.
DOJ Investigation
On July 9, 2002, we were informed by the U.S. Attorney’s Office for the District of Colorado of a criminal investigation of our business. We believe the U.S. Attorney’s 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. Attorney’s 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 requested exclusion from the proposed settlement of the consolidated securities action. Plaintiffs have variously alleged, among other things, that we and the other defendants 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 by issuing false and misleading financial reports and statements, falsely inflating revenue and decreasing expenses, creating false perceptions of revenue and growth prospects and/or employing improper accounting practices. 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. Plaintiffs variously seek, among other things, compensatory and punitive damages, restitution, equitable and declaratory relief, pre-judgment interest, costs and attorneys’ fees.
Opt-Outs with Previously-Filed Lawsuits. Together, the parties to these lawsuits contend that they have incurred losses resulting from their investments in our securities in excess of $900 million; they have also asserted claims for punitive damages and interest, in addition to claims to recover their alleged losses.
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Opt-Outs with Recently-Filed Lawsuits. Together, the parties to these lawsuits contend that they have incurred losses resulting from their investments in our securities of approximately $371 million; they have also asserted claims for punitive damages and interest, in addition to claims to recover their alleged losses.
Additional Opt-Out Parties. Since we announced the proposed settlement of the consolidated securities action, a number of additional persons, including large pension funds, have requested to be excluded from the class. Some of these additional opt-out parties have recently filed actions against us, which are included in the summary that appears above under “Opt-Outs with Recently-Filed Lawsuits.” We expect that other parties who have opted out will file actions against us as well if we are unable to resolve those matters amicably. The claims of those persons who requested to be excluded from the class will not be released as a result of the proposed settlement of the consolidated securities action, even in the event that the settlement is approved. In the aggregate, the persons who recently requested exclusion from the class, excluding those listed above under “Opt-Outs with Recently-Filed Lawsuits,” contend that they have incurred losses resulting from their investments in our securities of approximately $1.52 billion, which does not include any claims for punitive damages or interest. Due in part to the recent timing of the decisions by these persons to request exclusion from the proposed settlement of the consolidated securities action and to the fact that many of the persons who have requested exclusion have not filed lawsuits, it is difficult to evaluate the claims that they have asserted or may assert. We will vigorously defend against any such claims regardless of whether the proposed settlement of the consolidated securities action is consummated.
Other. A putative class action purportedly brought on behalf of purchasers of our stock between June 28, 2000 and June 27, 2002 and owners of U S WEST, Inc. stock on June 28, 2000 is pending in Colorado in the District Court for the County of Boulder. This action was filed on June 27, 2002. Plaintiffs allege, among other things, that we and other defendants issued false and misleading statements and engaged in improper accounting practices in order to accomplish the U S WEST/Qwest merger, to make us appear successful and to inflate the value of our stock. Plaintiffs seek unspecified monetary damages, disgorgement of illegal gains and other relief.
KPNQwest Litigation/Investigation
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 KPNQwest’s 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
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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 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 superior court granted defendants’ motion for partial summary judgment with respect to a substantial portion of plaintiffs’ claims. Plaintiffs have appealed that order to 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 and John McMaster. Plaintiffs allege, among other things, that defendants’ actions were a cause of the bankruptcy of KPNQwest and they seek damages for the bankruptcy deficit of KPNQwest of approximately $2.4 billion. Plaintiffs also seek treble 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,
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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 KPNQwest’s 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 KPNQwest’s former lenders if litigation is filed.
Regulatory Matter
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 Qwest’s 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 Commission’s Final Order. On February 24, 2006, the federal district court granted the defendants’ motion to dismiss, ruling that, under the Johnson Act, the Final Order was an order affecting rates that should be reviewed by the state court, not the federal court. Qwest has filed a motion for reconsideration.
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
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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, and we have done so.
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.
Other Matters
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, 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 the right-of-way as an easement 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, Mississippi, Missouri, 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 Internal Revenue Service (“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. On March 13, 2006, the Tax Court issued a decision, which was favorable to Qwest. The IRS sought rehearing and indicated that, if rehearing is denied, it will appeal the decision to the Tenth Circuit Court of Appeals. The trial for the 1997-1998 tax years has been tentatively scheduled for April or May 2007. If we ultimately 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 $45 million in interest pursuant to tax sharing agreements with the Anschutz Company relating to those time periods.
We have tax related matters pending against us, certain of which are before the Appeals Office of the IRS. In addition, tax sharing agreements have been executed between us and previous affiliates, and we believe the liabilities, if any, arising from adjustments to previously filed returns 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 recognized in our financial statements certain amounts owed to us under one of these agreements;
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however, generally, we have not provided for liabilities of former affiliated members or for claims they have asserted or may assert against us. We believe we have adequately provided for these tax-related matters. If the recorded reserves for these tax-related matters are insufficient, we may need to record additional amounts in future periods.
Note 9: Financial Statements of Guarantors
We and two of our subsidiaries, Qwest Capital Funding, Inc. (“QCF”) and Qwest Services Corporation (“QSC”), guarantee certain of each other’s registered debt securities. QCII issued a total of $2.575 billion aggregate principal amount of senior notes in February 2004 and June 2005 that are guaranteed by QCF and QSC (the “QCII Guaranteed Notes”). Between December 2002 and April 2003, QSC issued a total of $3.7 billion aggregate principal amount of senior subordinated secured notes (approximately $21 million of which remain outstanding) that are guaranteed by QCF and QCII on a senior unsecured basis (the “QSC Guaranteed Notes”). Each series of QCF’s outstanding notes totaling approximately $3.5 billion in aggregate principal amount (the “QCF Guaranteed Notes”) is guaranteed on a senior unsecured basis by QCII. The guarantees are full and unconditional, and joint and several. A significant amount of QCII’s and QSC’s income and cash flow are generated by their subsidiaries. As a result, funds necessary to meet each issuer’s debt service obligations are provided in large part by distributions or advances from their subsidiaries.
The following information sets forth our condensed consolidating balance sheets as of March 31, 2006 and December 31, 2005 and our condensed consolidating statements of operations and cash flows for the three months ended March 31, 2006 and 2005. The information for QCII, QSC and QCF is presented for each entity on a stand-alone basis, including that entity’s investments in all of its subsidiaries, if any, under the equity method. The condensed consolidating statements of operations and balance sheets include the effects of consolidating adjustments to our subsidiaries’ tax provisions and the related income tax assets and liabilities in the QSC and QCII results. The direct subsidiaries of QCII that are not guarantors of the QCII Guaranteed Notes or the QSC Guaranteed Notes are presented on a combined basis. The subsidiaries of QSC that are not guarantors of the QCII Guaranteed Notes or the QSC Guaranteed Notes are presented on a combined basis. Both QSC and QCF are 100% owned by QCII. Other than as already described herein, the accounting principles used are the same as those used in our condensed consolidated financial statements.
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Table of ContentsITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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, and references in this report to “QCII” refer to Qwest Communications International Inc. on an unconsolidated, stand-alone basis.
Certain statements set forth below under this caption constitute forward-looking statements. See “Special Note Regarding Forward-Looking Statements” at the end of this Item 2 for additional factors relating to such statements, and see “Risk Factors” in Item 1A of Part II 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 services outside our local service area as well as globally.
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 condensed consolidated financial statements in Item 1 of Part I 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 7—Segment Information to our condensed consolidated financial statements in Item 1 of Part I of this report. The following segment discussions reflect the way we currently report our operating results to our Chief Operating Decision Maker, or CODM, which includes revenue results for each of the customer channels within the wireline services segment: business, mass markets and wholesale. Certain prior year revenue, expense and access line amounts have been reclassified to conform to the current year presentations.
Business Trends
Our financial results continue to be impacted by several significant trends, which are described below:
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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 Part II of this report may also materially impact our business operations and financial results.
Results of Operations
Overview
We generate revenue from our wireline services, wireless services and other services as described below.
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.
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Table of ContentsThe following table summarizes our results of operations for the three months ended March 31, 2006 and 2005:
nm—percentages greater than 200% and comparisons from positive to negative values or to zero values are considered not meaningful.
Operating Revenue
The following table compares operating revenue by segment including the detail of customer channels within our wireline segment for the three months ended March 31, 2006 and 2005:
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