10-Q 1 d10q.txt FORM 10-Q FOR COMMONWEALTH TELEPHONE ENTERPRISES, INC. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition periods from __________ to _____________ Commission file number 0-11053 COMMONWEALTH TELEPHONE ENTERPRISES, INC. (Exact name of registrant as specified in its charter) Pennsylvania 23-2093008 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 100 CTE Drive Dallas, Pennsylvania 18612-9774 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (570) 631-2700 (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 requirement for the past 90 days. YES X NO As of June 30, 2002 there were 21,416,247 shares of the registrant's common stock, $1.00 par value per share, outstanding and 2,053,070 shares of the registrant's Class B common stock, $1.00 par value per share, outstanding. COMMONWEALTH TELEPHONE ENTERPRISES, INC. INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Statements of Operations and Comprehensive Income Three and Six Months ended June 30, 2002 and 2001 Condensed Consolidated Balance Sheets June 30, 2002 and December 31, 2001 Condensed Consolidated Statements of Cash Flows Six Months Ended June 30, 2002 and 2001 Notes to Condensed Consolidated Financial Statements Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations PART II. OTHER INFORMATION Item 1. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders Item 6. Exhibits and Reports on Form 8-K Item 7(a). Quantitative and Qualitative Disclosures about Market Risk SIGNATURES 2 PART I. FINANCIAL INFORMATION Item 1. Financial Statements COMMONWEALTH TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (Dollars in Thousands, Except Per Share Data) (Unaudited)
Three months ended Six months ended June 30, June 30, 2002 2001 2002 2001 ---------- ---------- ---------- ---------- Sales $ 78,300 $ 76,467 $ 156,696 $ 153,413 Costs and expenses, excluding other operating expenses itemized below 39,439 44,060 78,203 89,567 Management fees, related party 300 300 600 600 Depreciation and amortization 16,505 16,020 33,478 31,588 Restructuring charges (reversals) (2,057) (3,410) (2,057) (3,410) Voluntary employee retirement program - - 2,333 - ---------- ---------- ---------- ---------- Operating income 24,113 19,497 44,139 35,068 Interest and dividend income 491 365 1,372 1,565 Interest expense (3,248) (4,752) (6,597) (10,358) Other income, net 379 301 370 72 ---------- ---------- ---------- ---------- Income before income taxes 21,735 15,411 39,284 26,347 Provision for income taxes 8,982 7,014 16,010 12,191 ---------- ---------- ---------- ---------- Income before equity in unconsolidated entities 12,753 8,397 23,274 14,156 Equity in income of unconsolidated entities 1,345 1,272 1,573 1,409 ---------- ---------- ---------- ---------- Net income $ 14,098 $ 9,669 $ 24,847 $ 15,565 Cumulative effect of accounting change for derivative instruments, net of tax - - - (182) Unrealized gain (loss) on derivative instruments, net of tax (970) 222 (128) (731) ---------- ---------- ---------- ---------- Comprehensive net income $ 13,128 $ 9,891 $ 24,719 $ 14,652 ========== ========== ========== ========== Basic earnings per share: Net income $ 0.60 $ 0.42 $ 1.06 $ 0.68 ========== ========== ========== ========== Weighted average shares outstanding 23,374,395 23,049,794 23,363,307 22,989,850 Diluted earnings per share: Net income $ 0.60 $ 0.41 $ 1.05 $ 0.66 ========== ========== ========== ========== Weighted average shares and common stock equivalents outstanding 23,690,464 23,472,540 23,683,912 23,450,962
See accompanying notes to Condensed Consolidated Financial Statements. 3 COMMONWEALTH TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) (Unaudited)
June 30, December 31, 2002 2001 ---------- ------------ ASSETS Current assets: Cash and temporary cash investments $ 23,471 $ 27,298 Accounts receivable and unbilled revenues, net of reserve for doubtful accounts of $5,075 at June 30, 2002 and $3,047 at December 31, 2001 46,821 49,849 Other current assets 32,561 32,509 ---------- ---------- Total current assets 102,853 109,656 Property, plant and equipment, net of accumulated depreciation of $405,627 at June 30, 2002 and $381,888 at December 31, 2001 418,755 428,916 Investments 9,498 9,428 Deferred charges and other assets 17,364 15,676 Unamortized debt issuance costs 756 928 ---------- ---------- Total assets $ 549,226 $ 564,604 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt $ 9,010 $ 9,010 Notes payable 65,000 65,000 Accounts payable 33,491 41,961 Accrued restructuring expenses 4,060 7,381 Accrued expenses 44,918 51,993 Accrued income taxes 948 - Other current liabilities 5,144 5,258 Deferred income taxes - current 1,347 2,156 ---------- ---------- Total current liabilities 163,918 182,759 Long-term debt 116,805 151,309 Deferred income taxes 42,324 33,779 Other liabilities 34,977 31,241 Common shareholders' equity: Common stock 27,291 27,265 Additional paid-in capital 256,308 255,570 Deferred compensation (4,103) (4,306) Accumulated other comprehensive loss (3,007) (2,879) Retained earnings 45,692 20,845 Treasury stock at cost, 3,821,883 shares at June 30, 2002 and December 31, 2001 (130,979) (130,979) ---------- ---------- Total common shareholders' equity 191,202 165,516 ---------- ---------- Total liabilities and shareholders' equity $ 549,226 $ 564,604 ========== ==========
See accompanying notes to Condensed Consolidated Financial Statements. 4 COMMONWEALTH TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands) (Unaudited) Six months ended June 30, ------------------- 2002 2001 -------- -------- NET CASH PROVIDED BY OPERATING ACTIVITIES $ 52,103 $ 39,440 CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant & equipment (23,555) (29,297) Other 1,745 2,215 -------- -------- Net cash used in investing activities (21,810) (27,082) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Issuance of short-term debt - 65,000 Redemption of long-term debt (34,505) (64,505) Redemption of short-term debt - (30,000) Proceeds from exercise of stock options 450 5,932 Capital lease obligation (65) 358 -------- -------- Net cash used in financing activities (34,120) (23,215) -------- -------- Net decrease in cash and temporary cash investments (3,827) (10,857) -------- -------- Cash and temporary cash investments at beginning of year 27,298 37,046 -------- -------- Cash and temporary cash investments at June 30, $ 23,471 $ 26,189 ======== ======== Supplemental disclosures of cash flow information: Cash paid during the periods for: Interest $ 6,668 $ 10,031 ======== ======== Income taxes $ 7,816 $ 3,243 ======== ======== See accompanying notes to Condensed Consolidated Financial Statements. 5 COMMONWEALTH TELEPHONE ENTERPRISES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Thousands, Except Per Share Data) The Condensed Consolidated Financial Statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of our Management, the Condensed Consolidated Financial Statements include all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial information. The Condensed Consolidated Financial Statements should be read in conjunction with the financial statements and notes thereto included in our Form 10-K for the fiscal year ended December 31, 2001. 1. Background and Basis of Presentation - The consolidated financial statements of Commonwealth Telephone Enterprises, Inc. ("CTE," "we," "us" or "our") include the accounts of its wholly-owned subsidiaries, Commonwealth Telephone Company ("CT"), a rural incumbent local exchange carrier ("RLEC"); CTSI, LLC ("CTSI"), our RLEC edge-out operation; and other operations ("Other"), which include Commonwealth Communications ("CC"), a provider of telecommunications equipment and facilities management services; the portion of epix(R) Internet Services ("epix"), that includes revenue from Internet customers within CT's operating territory; the portion of Jack Flash(R) ("Jack Flash"), the digital subscriber line ("DSL") product offering in CT's franchise area; and Commonwealth Long Distance Company ("CLD"), a reseller of long-distance services. Other also includes our corporate financing entity. All significant intercompany accounts and transactions are eliminated. 2. Segment Information - CT provides local and long-distance telephone service to residential and business customers in a 19-county service territory in rural northeastern and central Pennsylvania. CT also provides network access and billing/collection services to interexchange carriers and sells telecommunications products and services. CTSI, which operates in three edge-out regional Pennsylvania markets that border CT's territory, is a competitive local exchange carrier, offering bundled local and long-distance telephone, Internet, DSL and enhanced services. The Other segment includes the results of CC and CLD, the portion of the results of epix that includes dial-up Internet customers within CT's territory, DSL customers within CT's territory and CTE's corporate financing entity. We have expanded certain financial information of CTSI to distinguish between the three ongoing edge-out markets and the five exited expansion markets which are included in our restructuring. We define adjusted EBITDA as earnings before interest, taxes, voluntary employee retirement program, restructuring charges (reversals), depreciation and amortization, other income (expense) and equity in income of unconsolidated entities. We believe that adjusted EBITDA is an additional measure of operations that (1) gauges the performance of our business and (2) may provide investors and research analysts with a benchmark against certain other communications companies. Adjusted EBITDA is not a measurement under U.S. Generally Accepted Accounting Principles (GAAP) and may not be comparable to other similarly titled measures of other companies. 6 Financial information by business segment is as follows: Quarter ended June 30, 2002 ---------------------------
CTSI CTSI Total CT Edge-Out Expansion CTSI Other Consolidated -------- -------- --------- --------- -------- ------------ Sales $ 51,072 $ 21,505 $ - $ 21,505 $ 9,660 $ 82,237 Elimination of intersegment sales 3,529 181 - 181 227 3,937 External sales 47,543 21,324 - 21,324 9,433 78,300 Adjusted EBITDA 30,180 7,878 - 7,878 503 38,561 Depreciation and amortization 11,262 4,630 - 4,630 613 16,505 Restructuring charges (reversals) - (2,057) - (2,057) - (2,057) Operating income (loss) 18,918 5,305 - 5,305 (110) 24,113 Interest expense, net (932) - (1,825) (2,757) Other income (expense), net (100) 501 (22) 379 Income (loss) before income taxes 17,886 5,806 (1,957) 21,735 Provision (benefit) for income taxes 7,004 2,726 (748) 8,982 Equity in income of unconsolidated entities - 1,345 - 1,345 Net income (loss) 10,882 4,425 (1,209) 14,098
Quarter ended June 30, 2001 ---------------------------
CTSI CTSI Total CT Edge-Out Expansion CTSI Other Consolidated -------- -------- --------- --------- -------- ------------ Sales $ 49,418 $ 18,266 $ 1,747 $ 20,013 $ 10,495 $ 79,926 Elimination of intersegment sales 3,166 172 7 179 114 3,459 External sales 46,252 18,094 1,740 19,834 10,381 76,467 Adjusted EBITDA 29,342 4,226 (1,468) 2,758 7 32,107 Depreciation and amortization 10,484 4,206 - 4,206 1,330 16,020 Restructuring charges (reversals) - - (3,410) (3,410) - (3,410) Operating income (loss) 18,858 20 1,942 1,962 (1,323) 19,497 Interest expense, net (1,879) - (2,508) (4,387) Other income (expense), net (365) 489 177 301 Income (loss) before income taxes 16,614 2,451 (3,654) 15,411 Provision (benefit) for income taxes 7,017 1,303 (1,306) 7,014 Equity in income of unconsolidated entities - 1,272 - 1,272 Net income (loss) 9,597 2,420 (2,348) 9,669
Six months ended June 30, 2002 ------------------------------
CTSI CTSI Total CT Edge-Out Expansion CTSI Other Consolidated -------- -------- --------- --------- -------- ------------ Sales $103,180 $ 42,538 $ - $ 42,538 $ 18,753 $ 164,471 Elimination of intersegment sales 7,021 333 - 333 421 7,775 External sales 96,159 42,205 - 42,205 18,332 156,696 Adjusted EBITDA 61,383 15,527 - 15,527 983 77,893 Depreciation and amortization 22,284 9,125 - 9,125 2,069 33,478 Restructuring charges (reversals) - (2,057) - (2,057) - (2,057) Voluntary employee retirement program - - - - 2,333 2,333 Operating income (loss) 39,099 8,459 - 8,459 (3,419) 44,139 Interest expense, net (1,422) - (3,803) (5,225) Other income (expense), net (95) 491 (26) 370 Income (loss) before income taxes 37,582 8,950 (7,248) 39,284 Provision (benefit) for income taxes 14,570 3,965 (2,525) 16,010 Equity in income of unconsolidated entities - 1,573 - 1,573 Net income (loss) 23,012 6,558 (4,723) 24,847
7 Six months ended June 30, 2001 ------------------------------
CTSI CTSI Total CT Edge-Out Expansion CTSI Other Consolidated -------- -------- --------- --------- -------- ------------ Sales $ 99,401 $ 35,204 $ 5,576 $ 40,780 $ 20,208 $ 160,389 Elimination of intersegment sales 6,471 275 13 288 217 6,976 External sales 92,930 34,929 5,563 40,492 19,991 153,413 Adjusted EBITDA 58,480 7,061 (2,650) 4,411 355 63,246 Depreciation and amortization 20,801 8,154 - 8,154 2,633 31,588 Restructuring charges (reversals) - - (3,410) (3,410) - (3,410) Operating income (loss) 37,679 (1,093) 760 (333) (2,278) 35,068 Interest expense, net (2,838) (1) (5,954) (8,793) Other income (expense), net (396) 513 (45) 72 Income (loss) before income taxes 34,445 179 (8,277) 26,347 Provision (benefit) for income taxes 14,545 555 (2,909) 12,191 Equity in income of unconsolidated entities - 1,409 - 1,409 Net income (loss) 19,900 1,033 (5,368) 15,565
3. Revenue Recognition - Local telephone service is recorded based on tariffed or contracted rates. Telephone network access and long-distance revenues are derived from access charges, toll rates and settlement arrangements. CT's interstate access charges are subject to a pooling process with the National Exchange Carrier Association ("NECA"). Final interstate revenues are based on nationwide average costs applied to certain demand quantities. Increases to CT's reserve for doubtful accounts are charged against revenue. Internet access service revenues are based on contracted fees. Long-distance telephone service revenues are recorded based on minutes of traffic processed and tariffed rates or contracted fees. Revenue from local telephone, Internet access and long-distance telephone services is earned and recorded when the services are provided. Long-term contracts of CC are accounted for on the percentage-of-completion method. We defer and amortize CT, CTSI and epix installation revenue as well as direct incremental service installation costs over their respective estimated customer life. We carry in the Consolidated Balance Sheets a deferred credit of $5,820 as of June 30, 2002 in other liabilities representing the unamortized portion of installation revenue. Additionally, we have a deferred charge of $5,820 as of June 30, 2002 in other assets representing the unamortized portion of installation costs. 4. Income Taxes - The provision for income taxes is different than the amount computed by applying the United States statutory federal tax rate primarily due to state income taxes net of federal benefit. In the third quarter of 2001, we implemented certain tax strategies to reduce our effective tax rate. These strategies included a reorganization of our legal entity structure that will allow the state of Pennsylvania tax losses of CTSI to be offset against taxable income of CT. Recently, the state of Pennsylvania passed legislation that increased the time frame for the utilization of Pennsylvania tax losses that may result in an additional benefit. Also, CT has taken advantage of certain tax incentives offered by the state of Pennsylvania aimed at attracting business into certain areas of qualifying cities in the state. We will have continued savings as a result of these tax strategies. 5. CTE Stock Options and Restricted Stock - At June 30, 2002, we have approximately 1,632,000 options outstanding at exercise prices ranging from $9.378 to $54.3125. During the first six months of 2002, 253,500 options were granted, 8,437 options were canceled and 23,071 options were exercised, yielding cash proceeds of $450. As provided for in the CTE Equity Incentive Plan, we granted 155,000 shares of restricted stock in 2000, of which 25,000 have been canceled. As of June 30, 2002, 65,000 shares were vested. The compensation cost recognized in 2002 was $769, in accordance with Accounting Principles Board (APB) Opinion No. 25 "Accounting for Stock Issued to Employees," as clarified by Interpretation No. 44 "Accounting for Certain Transactions Involving Stock Compensation" as issued by the FASB. 6. Earnings per Share - Basic earnings per share amounts are based on net income divided by the weighted average number of shares of Common Stock and Class B Common Stock outstanding during the period. Diluted earnings per share amounts are based on net income divided by the weighted average number of shares of Common Stock and Class B Common Stock 8 outstanding during each period after giving effect to dilutive common stock equivalents. The following table is a reconciliation of the numerators and denominators of the basic and diluted per share computations for net income:
Three months ended Six months ended June 30, June 30, ------------------------ ----------------------- 2002 2001 2002 2001 ----------- ----------- ----------- ---------- Net income $ 14,098 $ 9,669 $ 24,847 $ 15,565 =========== =========== =========== ========== Basic earnings per share: Weighted average shares outstanding 23,374,395 23,049,794 23,363,307 22,989,850 =========== =========== =========== ========== Net income per share $ 0.60 $ 0.42 $ 1.06 $ 0.68 =========== =========== =========== ========== Diluted earnings per share: Weighted average shares outstanding 23,374,395 23,049,794 23,363,307 22,989,850 Dilutive shares resulting from common stock equivalents 316,069 422,746 320,605 461,112 ----------- ----------- ----------- ---------- Weighted average shares and common stock equivalents outstanding 23,690,464 23,472,540 23,683,912 23,450,962 =========== =========== =========== ========== Net income per share $ 0.60 $ 0.41 $ 1.05 $ 0.66 =========== =========== =========== ==========
7. Derivative Instruments - We utilize interest rate swap agreements to reduce the impact of changes in interest rates on our floating rate debt. The swap agreements are contracts to exchange floating rate for fixed interest payments periodically over the life of the agreements without exchange of the underlying notional amounts. The notional amounts of interest rate swap agreements are used to measure interest to be paid or received and do not represent the amount of exposure to credit loss. Effective January 1, 2001, we adopted the provisions of SFAS 138: "Accounting for Certain Derivative Instruments and Certain Hedging Activities--an Amendment of FAS 133," in accounting for our interest rate swaps. The interest rate swaps meet the eligibility requirements for hedge accounting and are considered to be cash flow hedges. The fair value of the interest rate swaps is recorded in other liabilities on our Consolidated Balance Sheets. The effective portion of interest rate swap gains or losses is initially reported as a component of other comprehensive income and subsequently reclassified into earnings as an adjustment to interest expense. The ineffective portion, if any, is reported as other income (expense). The fair value of the interest rate swaps at January 1, 2001 was ($280). The transaction adjustment of $182, net of taxes of $98, is reported as a cumulative effect-type adjustment of accumulated other comprehensive loss. In the six months ended June 30, 2002, we recorded an adjustment of ($196) (($128) net of tax) to adjust the fair value of the swaps to ($4,626). In the six months ended June 30, 2001, we recorded an adjustment of $1,176 to adjust the fair value of the swaps, of which $52 was ineffective and recognized in current earnings, and $1,124 ($731 net of tax), which was recorded in other comprehensive income. The interest rate swaps are highly effective in achieving the offset of changes in cash flows of the underlying debt. We calculate the excess in the present value of the cumulative change in cash flows relating to the floating leg of the swaps as compared to the present value of the cumulative changes in interest cash outflows on the debt to measure ineffectiveness. 8. Restructuring Charges (Reversals) - In December 2000, we initiated an exit strategy for CTSI to reduce its network expansion plan from a total of eight 9 markets to three markets. This strategy was aimed at focusing on the three "edge-out" markets adjacent to CT's rural footprint. These edge-out markets encompass the Wilkes-Barre/Scranton/Hazleton, Harrisburg and Lancaster/Reading/York, PA markets. Related to this strategy, CTE recorded an estimated restructuring charge of $99,713 (pre-tax) and $64,813 (after-tax). CTSI had completed its withdrawal from the five non-"edge-out" expansion markets (suburban Philadelphia, PA; Binghamton, NY; Syracuse, NY; Charleston/Huntington, WV; and Youngstown, OH) by June 30, 2001. During December 2000, we reduced our workforce by approximately 220 employees and as of December 31, 2001 we reduced our workforce by an additional 33 employees who had remained to facilitate the transition of customers to other service providers. No further workforce reductions as a result of this restructuring will occur. Employee termination benefits associated with this workforce reduction and included in the restructuring charge was $2,628. Of this liability, $2,534 was paid and the remaining $94 was reversed in the fourth quarter of 2001. Also included in accrued restructuring expenses were estimated incremental costs associated with financial advisory, legal and other fees of $3,500. In 2000 and 2001, $1,328 was paid with $1,600 reversed in the second quarter of 2001 as a result of favorable negotiation of commitments. In the six months ended June 30, 2002, $41 of this liability was paid and the remaining $531 was reversed in the second quarter of 2002 due to lower than anticipated legal expenses. Additionally, other exit costs associated with terminating customer contracts, committed purchases of equipment, building and circuit lease terminations, asset removal and site restorations were estimated to be $17,580. During 2001, $6,213 was paid. In the second quarter 2001, $1,810 associated with a canceled committed equipment purchase that was favorably negotiated was reversed. In the third quarter 2001, as a result of the sale of certain assets and the assignment of certain leases to a CLEC, we reversed $2,233 of these charges. In the fourth quarter 2001, $515 was reversed due to a favorable building lease settlement. In the six months ended June 30, 2002, $1,223 of this liability was paid. In the second quarter of 2002, $1,526 was reversed due to the elimination of liabilities associated with certain customer contracts. We expect the majority of the remaining liabilities to be utilized in 2002. Any funding associated with the reduction of the outstanding liabilities at June 30, 2002 of $4,060 will come from cash flow from operations or existing credit facilities. The restructuring charge as of December 31, 2000 included $73,994, net of estimated salvage value, for the write-down of assets included in property, plant and equipment. Estimated salvage values were based on estimates of proceeds from the sale of the affected assets, offset by costs of removal. These assets primarily relate to switching, central office equipment and outside communications plant physically located in the exited markets. In July 2001, a CLEC purchased a portion of our assets in the New York expansion markets at amounts higher than estimated, resulting in a gain of $3,035. No depreciation expense was recorded for the expansion markets in 2001 or 2002. No further depreciation expense will be incurred for these expansion market assets. The restructuring charge also included $2,011 related to the write-down, net of estimated salvage value, of assets included in inventory to be sold or disposed of in connection with the restructuring. The write-down of the assets to be disposed of was a direct result of our unwillingness to incur the capital requirements necessary to grow these markets and make them profitable; and accordingly, no future cash flows from these assets could be anticipated. Excluding the expansion market assets, we are not aware of any events or circumstances that would suggest the carrying amount of our remaining assets would not be recoverable. 10 The key elements of the restructuring charge recorded in December 2000 were:
Assets, Employee Disposal Termination Contract and Removal Benefits Terminations Costs Other Total ----------- ------------ ----- ----- ----- Employee termination benefits $2,628 $ 2,628 Contract terminations and settlements $15,294 15,294 Removal and restoration costs $ 2,286 2,286 Write-down of assets 76,005 76,005 Investment advisory and other fees $3,500 3,500 ------ ------- ------- ------ ------- Total restructuring charges $2,628 $15,294 $78,291 $3,500 $99,713 ====== ======= ======= ====== =======
Accrued restructuring expense comprises the following:
Balance Reversal Balance Reversal Balance December 31, of December 31, of June 30, Provision Payments 2000 Payments Provision 2001 Payments Provision 2002 --------- -------- ------------ -------- --------- ------------ -------- --------- --------- Employee termination benefits $ 2,628 $(1,572) $ 1,056 $ (962) $ (94) $ - $ - $ - $ - Contract terminations and settlements 15,294 - 15,294 (5,150) (3,788) 6,356 (1,223) (1,526) 3,607 Removal and restoration costs 2,286 - 2,286 (1,063) (770) 453 - - 453 Investment advisory and other fees 3,500 (311) 3,189 (1,017) (1,600) 572 (41) (531) - ------- ------- ------- ------- ------- ------- -------- -------- --------- Total accrued restructuring expenses $23,708 $(1,883) $21,825 $(8,192) $(6,252) $ 7,381 $ (1,264) $ (2,057) $ 4,060 ======= ======= ======= ======= ======= ======= ======== ======== =========
We have not realized and do not anticipate any significant change to non-expansion market revenues or costs as a result of this event. 9. Voluntary Retirement Program - On December 12, 2001, we initiated a Voluntary Retirement Program ("VRP"). The program was offered to certain eligible employees across all of our operations. The VRP is largely being funded from pension assets and, therefore, nearly 80% of the cost is non-cash to the Company. Since the deadline related to this program extended into 2002, and because only a portion of the eligible employees had made a decision to accept this program prior to year-end 2001, $2,333 ($1,423 after-tax) was recorded in the first quarter of 2002. The VRP costs of $2,333 represent $1,805 of non-cash charges related to pension enhancement, social security supplements and vacation benefits. Other VRP program costs of $528 relate to medical insurance and other program expenses. 10. Debt - On April 6, 2001, we amended our September 15, 2000, 364-day revolving line of credit agreement with CoBank to provide for an additional $35,000 of borrowing capacity and to change other terms and conditions of the loan. In April 2002, the maturity was extended to June 2002. The amended revolving line of credit agreement with CoBank was entered into on June 4, 2002 that extended the availability of credit to June 2003. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Dollars in Thousands, Except Per Share Data) This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act and we intend that such forward-looking statements be subject to these safe harbors. These statements are generally accompanied by words such as "intend," "anticipate," "believe," "estimate," "expect" or similar statements. Our forward-looking statements involve risks and uncertainties that could significantly affect expected results in the future differently than expressed in any forward-looking statements we have made. These risks and uncertainties include, but are not limited to: 11 . uncertainties relating to our ability to further penetrate our markets and the related cost of that effort; . economic conditions, acquisitions and divestitures; . government and regulatory policies; . the pricing and availability of equipment, materials and inventories; . technological developments; and . changes in the competitive environment in which we operate. Although we believe that the assumptions underlying our forward-looking statements are reasonable, any of the assumptions could prove inaccurate and, therefore, we cannot provide any assurance that the results contemplated in such forward-looking statements will be realized. The inclusion of this forward-looking information should not be regarded as a representation by us or any other person that the future events, plans or expectations that we contemplate will be achieved. Furthermore, past performance in operations and share price is not necessarily predictive of future performance. The following discussion should be read in conjunction with the attached Condensed Consolidated Financial Statements and notes thereto and with the Company's audited financial statements and notes thereto included in the Company's Form 10-K for the fiscal year ended December 31, 2001. Overview and Segments Our two primary operations are Commonwealth Telephone Company, or CT, which is a rural incumbent local exchange carrier ("RLEC"), and CTSI, LLC, our RLEC edge- out operation. We also have another business segment labeled "Other" which is comprised of telecommunications-related businesses that all operate in the deregulated segments of the telecommunications industry and support the operations of our two primary operating companies. These support businesses are epix(R) Internet Services, a rural Internet service provider; Jack Flash(R), a broadband data service that uses DSL technology to offer high-speed Internet access and digital connectivity solutions; Commonwealth Communications, a provider of telecommunications equipment and facilities management services; and Commonwealth Long Distance Company, a facilities-based long-distance reseller. Both epix and Jack Flash results included in Other represent the portion of these businesses in our RLEC's territory. Other also includes our corporate financing entity. Our RLEC has been operating in various rural Pennsylvania markets since 1897. As of June 30, 2002, our RLEC served over 335,000 switched access lines. In 1997, we formally launched our facilities-based RLEC edge-out operation. CTSI operates in three "edge-out" regional Pennsylvania markets that border our RLEC's markets and that we believe offer attractive market demographics such as higher population density and a higher concentration of businesses. CTSI served over 119,000 switched access lines as of June 30, 2002, which were mainly business customers. Beginning in 1998, CTSI expanded beyond its original three "edge-out" markets into five additional expansion markets in Pennsylvania, New York, Ohio and West Virginia. At the end of 2000, we developed an exit strategy for these "expansion" markets in order to refocus our attention on our three original "edge-out" markets. This strategy has allowed us to grow our adjusted EBITDA and significantly reduced our capital needs. We had completed our withdrawal from these markets by June 30, 2001. Revenue Our RLEC revenue is derived primarily from access, local service, enhanced services and intraLATA toll. IntraLATA toll revenue is derived from customers who have chosen us to provide intrastate long-distance service. Access revenue consists primarily of charges paid by long-distance companies for access to our network in connection with the completion of long-distance telephone calls. Local service revenue consists of charges for local exchange telephone services, including monthly tariffs for basic local service. Enhanced services revenue is derived from service for special calling features, such as Caller ID and Call Waiting. 12 CTSI's revenue is derived primarily from access, local service, point-to-point circuit, Internet access, DSL and long-distance service revenue. Access revenue consists primarily of charges paid by long-distance companies and other carriers for access to our network in connection with the completion of long-distance telephone and local calls and the delivery of other services. Local service revenue consists of charges for local exchange telephone services, including monthly recurring charges for basic services and special calling features. Competitive access revenue consists of charges for point-to-point connections. Internet access revenue consists of charges for dial-up Internet access provided to CTSI customers. DSL revenue consists of charges for high-speed Internet access and digital connectivity solutions provided to CTSI customers. Long-distance revenue consists of charges for long-distance service paid by CTSI customers. Our "Other" business segment includes a portion of the revenue from epix(R) Internet Services and Jack Flash(R) and all of the revenues from Commonwealth Communications and Commonwealth Long Distance Company. epix revenue for this segment consists of Internet revenue from customers within the RLEC service territory and non-CTSI customers outside the RLEC territory. Jack Flash revenue for this segment consists of charges for DSL service from customers within the RLEC service territory. Commonwealth Communications generates revenue primarily from telecommunications projects including installation of PBX systems for business customers, cabling projects and telecommunication systems design. Commonwealth Long Distance primarily derives its revenue from long-distance customers within the RLEC operating territory. Operating Costs Our operating costs and expenses for each of our segments primarily include access charges and other direct costs of sales, payroll and related benefits, selling and advertising, software and information system services and general and administrative expenses. These costs have increased over time as we have grown our operations and revenues. We expect these costs to continue to increase as our revenue growth continues, but generally at a slower rate than revenue growth. CTSI also incurs additional costs related to leased local loop charges associated with providing last mile access, circuit rentals, engineering costs, colocation expense, terminating access for local calls and long-distance expense. Commonwealth Long Distance also incurs long-distance expense associated with purchasing long-distance minutes on a wholesale basis from a third party provider. Commonwealth Communications also incurs expenses primarily related to equipment and materials used in the course of the installation and provision of service. Capital Expenditures We incur line-related capital expenditures associated with access line growth, maintenance expenditures for upgrading existing facilities and costs related to the provisioning of DSL services in our RLEC and RLEC edge-out territories. Capital expenditures associated with access line growth, comprising a significant portion of our overall capital spending, are success-based and therefore result in incremental revenue. Results of Operations Quarters ended June 30, 2002 vs June 30, 2001 Our consolidated sales were $78,300 and $76,467 for the quarters ended June 30, 2002 and 2001, respectively. Contributing to the sales increase of $1,833 or 2.4% were higher sales of CT of $1,291 and higher CTSI edge-out sales of $3,230, partially offset by the loss of CTSI expansion sales of $1,740 and a decline of $948 in Other sales. CT's revenue was reduced by a $2,000 charge related to WorldCom receivables that was recorded as contra-revenue in June 2002. Our consolidated operating income was $24,113 for the quarter ended June 30, 2002 as compared to $19,497 for the quarter ended June 30, 2001. The increase in operating income of $4,616 was primarily the result of increased consolidated sales and lower costs in providing these sales, partially offset by increased 13 consolidated depreciation expense and a smaller positive settlement in 2002 associated with our 2000 restructuring charge. Consolidated net income was $14,098 or $0.60 per diluted share for the quarter ended June 30, 2002 and $9,669 or $0.41 per diluted share for the quarter ended June 30, 2001. Contributing to the increase of $4,429 is the increase in operating income discussed above and a reduction in interest expense, partially offset by an increase in the provision for income taxes. Six months ended June 30, 2002 vs June 30, 2001 Consolidated sales were $156,696 and $153,413 for the six months ended June 30, 2002 and 2001, respectively. Contributing to the sales increase of $3,283 or 2.1% were higher sales of CT of $3,229 and higher CTSI edge-out sales of $7,276, partially offset by the loss of CTSI expansion sales of $5,563 and a decline of $1,659 in Other sales. CT's revenue was reduced by a $2,000 charge related to WorldCom receivables that was recorded as contra-revenue in June 2002. Our consolidated operating income was $44,139 for the six months ended June 30, 2002 as compared to $35,068 for the six months ended June 30, 2001. The increase in operating income of $9,071 or 25.9% was primarily the result of increased consolidated sales and lower costs in providing these sales, partially offset by increased consolidated depreciation expense, a smaller positive settlement in 2002 associated with our 2000 restructuring charge and expenses recorded in connection with the Voluntary Retirement Program that was initiated in December 2001. Consolidated net income was $24,847 or $1.05 per diluted share for the six months ended June 30, 2002 and $15,565 or $0.66 per diluted share for the six months ended June 30, 2001. Contributing to the increase of $9,282 is the increase in operating income discussed above and a reduction in interest expense, partially offset by an increase in the provision for income taxes. Selected Segment Data Adjusted EBITDA We provide as supplemental data our adjusted EBITDA on both a consolidated and segment basis. We define adjusted EBITDA as earnings before interest, taxes, voluntary employee retirement program, restructuring charges (reversals), depreciation and amortization, other income (expense) and equity in income of unconsolidated entities. We believe that adjusted EBITDA is an additional measure of operations that (1) gauges the performance of our business; and (2) may provide investors and research analysts with a benchmark against certain other communications companies. Adjusted EBITDA is not a measurement under GAAP and may not be comparable to other similarly titled measures of other companies. Pro forma data The pro forma data presented gives effect to CTSI's exit from five expansion markets in 2001. The pro forma data is calculated by eliminating sales and identifiable direct operating expenses related to our operations in the expansion markets for the periods presented. However, the pro forma data is not necessarily indicative of the results we would have achieved had we actually completed the exit before January 2001, or of our results of future operations. 14
Sales: Quarters ended Six months ended June 30, June 30, -------------------------------- ----------------------------- Pro forma Pro forma 2002 2001 2001/*/ 2002 2001 2001/*/ ------- ------- --------- -------- -------- -------- CT $47,543 $46,252 $ 46,252 $ 96,159 $ 92,930 $ 92,930 ------- ------- --------- -------- -------- -------- CTSI - edge-out 21,324 18,094 18,094 42,205 34,929 34,929 CTSI - expansion - 1,740 - - 5,563 - ------- ------- --------- -------- -------- -------- Total CTSI 21,324 19,834 18,094 42,205 40,492 34,929 ------- ------- --------- -------- -------- -------- Other 9,433 10,381 10,381 18,332 19,991 19,991 ------- ------- --------- -------- -------- -------- Total $78,300 $76,467 $ 74,727 $156,696 $153,413 $147,850 ======= ======= ========= ======== ======== ========
Operating income (loss): Quarters ended Six months ended June 30, June 30, -------------------------------- ----------------------------- Pro forma Pro forma 2002 2001 2001/*/ 2002 2001 2001/*/ ------- ------- --------- -------- -------- --------- CT $18,918 $18,858 $ 18,858 $ 39,099 $ 37,679 $ 37,679 ------- ------- --------- -------- -------- -------- CTSI - edge-out 5,305 20 20 8,459 (1,093) (1,093) CTSI - expansion - 1,942 - - 760 - ------- ------- --------- -------- -------- -------- Total CTSI 5,305 1,962 20 8,459 (333) (1,093) ------- ------- --------- -------- -------- -------- Other (110) (1,323) (1,323) (3,419) (2,278) (2,278) ------- ------- --------- -------- -------- -------- Total $24,113 $19,497 $ 17,555 $ 44,139 $ 35,068 $ 34,308 ======= ======= ========= ======== ======== ========
Adjusted EBITDA: Quarters ended Six months ended June 30, June 30, ------------------------------- ----------------------------- Pro forma Pro forma 2002 2001 2001/*/ 2002 2001 2001/*/ ------- ------- --------- -------- -------- -------- CT $30,180 $29,342 $ 29,342 $ 61,383 $ 58,480 $ 58,480 ------- ------- --------- -------- -------- -------- CTSI - edge-out 7,878 4,226 4,226 15,527 7,061 7,061 CTSI - expansion - (1,468) - - (2,650) - ------- ------- --------- -------- -------- -------- Total CTSI 7,878 2,758 4,226 15,527 4,411 7,061 ------- ------- --------- -------- -------- -------- Other 503 7 7 983 355 355 ------- ------- --------- -------- -------- -------- Total $38,561 $32,107 $ 33,575 $ 77,893 $ 63,246 $ 65,896 ======= ======= ========= ======== ======== ========
15 Installed access lines: June 30, ----------------------------------- Pro forma 2002 2001 2001/*/ ------- ------- -------- CT 335,467 323,971 323,971 ------- ------- ------- CTSI - edge-out 119,471 105,090 105,090 CTSI - expansion - - - ------- ------- ------- Total CTSI 119,471 105,090 105,090 ------- ------- ------- Total 454,938 429,061 429,061 ======= ======= ======= * The pro forma data is calculated by eliminating sales, identifiable direct operating expenses and restructuring charges (reversals) related to our operations in the expansion markets for the periods presented. Commonwealth Telephone Company Sales were $47,543 and $46,252 for the quarters ended June 30, 2002 and 2001, respectively. The sales increase of $1,291 or 2.8% is primarily due to higher access, enhanced services and local service revenues resulting from an increase in installed access lines of 11,496 or 3.5%. CT's successful marketing of residential additional lines and sales of business lines contributed to the access line growth. Residential additional line penetration was approximately 40% at June 30, 2002 as compared to approximately 37% at June 30, 2001. The 2002 revenue was reduced by a $2,000 charge related to WorldCom receivables that was recorded as contra-revenue. CT's sales were $96,159 and $92,930 for the six months ended June 30, 2002 and 2001, respectively. The sales increase of $3,229 or 3.5% is primarily due to higher access, enhanced services and local service revenues resulting from an increase in installed access lines, partially offset by the $2,000 charge related to WorldCom receivables. Interstate access revenue increased $1,651 and $2,935 for the three and six months ended June 30, 2002, versus the comparable period of 2001, resulting from an increase in the NECA average schedule formulas in July 2001, growth in access lines and an increase in minutes of use. State access revenue increased $1,288 and $2,343 for the three and six months ended June 30, 2002 as compared to the comparable period of 2001, primarily a result of an increase in minutes and access line growth. Local service revenue increased $270 and $561 for the three and six months ended June 30, 2002, as compared to the same period last year, primarily as a result of the increase in access lines and a rate increase in May 2002. Enhanced services revenue increased $349 and $666 for the three and six months ended June 30, 2002 in comparison to the same period last year primarily as a result of increases in Caller ID and certain other custom calling sales. IntraLATA toll revenue decreased $382 and $804 for the three and six months ended June 30, 2002 as compared to the comparable period of 2001, primarily as a result of lower market share due to customers selecting alternate lower cost service providers and attractive calling packages offered by several non-wireline providers in certain areas of CT's territory. We expect this trend to continue. Costs and expenses excluding depreciation, amortization, management fees, voluntary employee retirement program and restructuring charges (reversals) for the quarter ended June 30, 2002 were $17,063 as compared to $16,610 for the quarter ended June 30, 2001. Contributing to the increase of $453 or 2.7% are higher payroll costs resulting from annual salary increases and performance-based incentives and higher expenses for additional advertising partially offset by favorable reductions in Pennsylvania capital stock tax due to certain tax incentives offered by the state of Pennsylvania aimed at attracting business into certain areas of qualifying cities in the state. 16 For the six months ended June 30, 2002, costs and expenses excluding depreciation, amortization, management fees, voluntary employee retirement program and restructuring charges (reversals) were $34,176 as compared to $33,850 for the six months ended June 30, 2001. Contributing to the increase of $326 or 1.0% are higher payroll costs resulting from annual salary increases and performance-based incentives. Also contributing to the increase are higher expenses for additional advertising, partially offset by favorable reductions in Pennsylvania capital stock tax due to certain tax incentives offered by the state of Pennsylvania aimed at attracting business into certain areas of qualifying cities in the state and lower expenses associated with fewer business system sales. CTSI CTSI sales were $21,324 (edge-out $21,324; expansion $0) for the quarter ended June 30, 2002 as compared to $19,834 (edge-out $18,094; expansion $1,740) for the same period in 2001. The increase of $3,230 or 17.9% in the edge-out markets primarily represents an increase in local service, access and customer point-to-point circuit revenues. The increase in revenue is in part the result of an increase in installed access lines. At June 30, 2002, CTSI edge-out markets had 119,471 installed access lines versus 105,090 edge-out market installed access lines at June 30, 2001, an increase of 14,381 or 13.7%. Also contributing to the increase in revenue was an increase in Internet service provider ("ISP")-related traffic. For the quarter ended June 30, 2002, CTSI recorded approximately $2,881 or 13.5% of its edge-out market revenues from revenue associated with ISP traffic, as compared to $2,459 or 13.6% for the same period last year. Regulatory developments during 2001 are expected to adversely affect CTSI's revenues in future periods. See "Legislative and Regulatory Developments." The increase in point-to-point circuit revenue is due to Internet and cellular providers using our circuits to allow their networks to tie into the switched network system. CTSI sales were $42,205 (edge-out $42,205; expansion $0) for the six months ended June 30, 2002 as compared to $40,492 (edge-out $34,929; expansion $5,563) for the same period in 2001. The increase of $7,276 or 20.8% in the edge-out markets primarily represents an increase in local service, access and customer point-to-point circuit revenues. The increase in revenue is in part the result of an increase in installed access lines of 14,381 in the edge-out markets for the period and increased ISP traffic. Internet and cellular providers using our circuits to allow their networks to tie into the switched network system contributed to an increase of $1,647 in point-to-point circuit revenue. For the six months ended June 30, 2002, CTSI recorded approximately $5,974 or 14.2% of its edge-out market revenues from revenue associated with ISP traffic, as compared to $4,304 or 12.3% for the same period last year. Costs and expenses, excluding depreciation, amortization, management fees, voluntary employee retirement program and restructuring charges (reversals) were $13,347 (edge-out $13,347; expansion $0) and $16,977 (edge-out $13,769; expansion $3,208) for the quarters ended June 30, 2002 and 2001, respectively. For the six months ended June 30, 2002, costs and expenses, excluding depreciation, amortization, management fees, voluntary employee retirement program and restructuring charges (reversals) were $26,480 (edge-out $26,480; expansion $0) as compared to $35,883 (edge-out $27,670; expansion $8,213) for the six months ended June 30, 2001. Contributing to the decrease in expenses for the edge-out markets are a lower effective monthly rate for leased loops, reduced bad debt expense due to improved collection efforts and a reduction in terminating access charges from independent local exchange carriers. These lower expenses were partially offset by additional circuit rental expense, higher management information systems charges and increased payroll costs resulting from annual salary increases and performance-based incentives. The decline in the expenses of the expansion markets is due to our exit from those markets. 17 Other Sales of our support businesses were $9,433 and $10,381 for the quarters ended June 30, 2002 and 2001, respectively. The decline of $948 or 9.1% is due primarily to a decline in CC and CLD sales, offset by an increase in Jack Flash sales. CC sales decreased $563 or 12.2% primarily due to a decrease in premises distribution system (cabling projects) and business systems upgrades sales. CLD sales declined $406 or 25.2% as a result of customers switching to alternate long-distance providers due to CLD's above-average long-distance rates. epix sales decreased $195 or 5.3% due to a decrease in dial-up subscribers. At June 30, 2002, Jack Flash had 8,511 installed DSL subscribers as compared to 5,616 at June 30, 2001, contributing to its increase in revenue of $216. For the six months ended June 30, 2002, sales of our support businesses were $18,332 as compared to $19,991 for the six months ended June 30, 2001. The decline of $1,659 or 8.3% is due primarily to a decline in CC sales of $1,002 or 11.8%, decreased CLD sales of $899 or 26.9% and decreased epix sales of $201 or 2.8%, offset by an increase in Jack Flash sales of $443. Costs and expenses of our support businesses, excluding depreciation, amortization, management fees, voluntary employee retirement program and restructuring charges (reversals) were $9,029 and $10,473 for the three months ended June 30, 2002 and 2001, respectively. For the six months ended June 30, 2002, costs and expenses of our support businesses, excluding depreciation, amortization, management fees, voluntary employee retirement program and restructuring charges (reversals) were $17,547 as compared to $19,834 for the six months ended June 30, 2001. CC costs and expenses decreased $565 and $890 for the three and six months ended June 30, 2002, as compared to the same periods last year, due primarily to the decrease in sales. CLD costs and expenses decreased $624 and $893 for the three and six months ended June 30, 2002, as compared to the same periods last year, due primarily to the decrease in sales. epix expenses decreased $292 and $725 for the three and six months ended June 30, 2002, in comparison to the same periods last year due to lower transport costs and a reduction in headcount. DSL costs decreased $306 and $784 for the three and six months ended June 30, 2002, as compared to the same periods last year, due to lower advertising costs and a reduction in the number of people focused on Jack Flash. Adjusted EBITDA Consolidated adjusted EBITDA was $38,561 and $32,107 for the quarters ended June 30, 2002 and 2001, respectively. The increase of $6,454 or 20.1% is primarily due to increased consolidated sales and decreased consolidated costs and expenses, as previously discussed. The adjusted EBITDA for the three months ended June 2001 includes losses in the CTSI expansion markets of $1,468. Consolidated adjusted EBITDA was $77,893 and $63,246 for the six months ended June 30, 2002 and 2001, respectively. The increase of $14,647 or 23.2% is primarily due to increased consolidated sales and decreased consolidated costs and expenses, as previously discussed. The adjusted EBITDA for the six months ended June 2001 includes losses in the CTSI expansion markets of $2,650. Depreciation and amortization Consolidated depreciation and amortization increased $485 or 3.0% for the quarter ended June 30, 2002 as compared to the quarter ended June 30, 2001. For the six months ended June 30, 2002, depreciation and amortization increased $1,890 or 6.0%. The increase for the three and six month periods is primarily due to a higher depreciable plant balance as a result of CT and CTSI capital expenditures during 2001 and 2002. Voluntary Employee Retirement Program On December 12, 2001, we initiated a Voluntary Retirement Program ("VRP"). The program was offered to certain eligible employees across all of our operations. The VRP is largely being funded from pension assets and, therefore, nearly 80% of the cost is non-cash to the Company. Since the deadline related to this 18 program extended into 2002, and because only a portion of the eligible employees had made a decision to accept this program prior to year-end 2001, $2,333 ($1,423 after-tax) was recorded in the first quarter of 2002. The VRP costs of $2,333 represent $1,805 of non-cash charges related to pension enhancement, social security supplements and vacation benefits. Other VRP program costs of $528 relate to medical insurance and other program expenses. As a result of the VRP, we reduced our headcount by 103 employees, or approximately 7% of our overall workforce. The results of this program allowed us to achieve increased efficiency and reduced costs. Interest expense Interest expense includes interest on CT's mortgage note payable to CoBank, ACB ("CoBank"), interest on CTE's revolving credit facility and amortization of debt issuance costs. We used interest rate swaps on $105,000 of floating rate debt to hedge against interest rate exposure. Consolidated interest expense was $3,248 and $4,752 for the quarters ended June 30, 2002 and 2001, respectively; this represents a decrease of $1,504 or 31.6% from the comparable period of 2001. Consolidated interest expense was $6,597 and $10,358 for the six months ended June 30, 2002 and 2001, respectively; this represents a decrease of $3,761 or 36.3% from the comparable period of 2001. The decrease in interest expense is primarily due to lower average debt outstanding and lower interest rates on variable rate debt not subject to interest rate swaps. Interest expense on CT's mortgage note payable to CoBank decreased as a result of scheduled principal payments. Income taxes Our effective income tax rates were 38.9% and 42.0% for the quarters ended June 30, 2002 and 2001, respectively. For the six months ended June 30, 2002 and 2001, our effective income tax rates were 39.2% and 43.9%, respectively. In July of 2001, we implemented certain tax strategies to reduce our effective tax rate. These strategies included a reorganization of our legal entity structure that will allow the state of Pennsylvania tax losses of CTSI to be offset against taxable income of CT. Also, CT has taken advantage of certain tax incentives offered by the state of Pennsylvania aimed at attracting business into certain areas of qualifying cities in the state. Liquidity and capital resources: June 30, December 31, 2002 2001 -------- -------- Cash and temporary cash investments $ 23,471 $ 27,298 Working capital deficit $(61,065) $(73,103) Long-term debt (including current maturities and notes payable) $190,815 $225,319 Six months ended June 30, 2002 2001 -------- -------- Net cash provided by operating activities $ 52,103 $ 39,440 Investing activities: Additions to property, plant and equipment $(23,555) $(29,297) 19 We have the following financing arrangements in place that provide liquidity based on our current needs. Aggregate amounts available under existing facilities were $175,000 at June 30, 2002 and $105,000 at June 30, 2001. June 30, 2002 June 30, 2001 ------------------- ------------------- Balance Available Balance Available -------- --------- -------- --------- Revolving credit facility $ 65,000 $ 175,000 $135,000 $ 105,000 Credit agreement - CoBank 60,815 - 69,824 - Revolving line of credit - CoBank 65,000 - 65,000 - -------- --------- -------- --------- Total $190,815 $ 175,000 $269,824 $ 105,000 ======== ========= ======== ========= Cash and temporary cash investments were $23,471 at June 30, 2002 as compared to $27,298 at December 31, 2001. Our working capital ratio was 0.63 to 1 at June 30, 2002 as compared to 0.60 to 1 at December 31, 2001. The net increase is due to increased liquidity provided by operations and reductions in capital spending. For the six months ended June 30, 2002, our net cash provided by operating activities was $52,103 comprised of net income of $24,847, non-cash depreciation and amortization of $33,478 and other non-cash items and working capital changes resulting in a reduction of $6,222. Net cash used in investing activities of $21,810 consisted primarily of additions to property, plant and equipment of $23,555, partially offset by proceeds on retired assets. Net cash used in financing activities of $34,120 consisted primarily of the net redemption of debt of $34,505, partially offset by proceeds of stock option exercises of $450. We expect to have adequate resources to meet our currently foreseeable obligations and development plans for our CTSI edge-out markets and customer demand for additional capacity and service. In addition to cash generated from operations and existing credit facilities, sources of funding for any additional capital requirements or acquisitions may include financing from public offerings or private placements of equity and/or debt securities and bank loans. There can be no assurance that additional financing will be available to us or, if available, that it can be obtained on a timely basis and on acceptable terms. Failure to obtain such financing could result in the delay or curtailment of our development plans and expenditures. We have a $65,000 revolving line of credit with CoBank. This agreement contains restrictive covenants which, among other things, requires the maintenance of a specific debt to cash flow ratio. As amended in June 2002, the revolving line of credit agreement provides for the availability of credit to June 2003. On April 2, 2002, we completed a 4,898,000 share secondary equity offering of our common stock. All of these shares were offered by a subsidiary of Level 3 Communications, Inc. As such, we did not receive any proceeds from the sale of shares in this offering. We may, from time to time, consider purchasing some or all of our shares held by Level 3 Communications, Inc. and its affiliates in one or more transactions and may finance these purchases through public or private offerings of equity or debt, operating cash flows and/or bank loans. Related and Like Parties Level 3 Communications, Inc. ("Level 3") holds a significant portion of the voting power in our equity securities. Four of our directors are also directors of Level 3. Level 3 will continue to have significant influence over the election of our directors and our corporate and management policies, including potential mergers or acquisitions, asset sales and other significant corporate transactions. We have existing relationships with RCN Corporation ("RCN"), which is an affiliate of Level 3. Our Chairman, David McCourt, is also the Chairman and CEO of RCN Corporation, a facilities-based telecommunications company. Eight of our directors also serve on the board of directors of RCN. We have entered into a month-to-month long-distance resale agreement and a management service agreement with RCN, the latter of which was not the result of arm's-length negotiations. In addition, Level 3 owns approximately 26% of the outstanding equity securities of RCN. Level 3 maintains certain rights to register its shares for resale and has stated publicly that it would consider monetizing certain of its non-core assets, including its holdings in public companies such as our company. 20 Legislative and Regulatory Developments Commonwealth Telephone Company Our RLEC is subject to regulation by the Pennsylvania Public Utility Commission for intrastate ratemaking purposes, which includes rates for basic local services, intraLATA toll services and access services for the origination and termination of in-state long-distance calls. In 1997, our RLEC entered into an alternative regulatory framework with the Public Utility Commission for all of its intrastate operations under which it agreed to meet certain broadband service delivery parameters in exchange for a price cap formula, rather than rate of return regulations. As a result of the alternative regulatory framework, our RLEC's profits are not directly limited by the Commission as they were under the former rate of return system of regulation. Instead, our RLEC received the flexibility to increase local rates annually based on inflation less 2 percentage points, so that increased returns arising from improved productivity and efficiency in excess of 2% per annum accrue to the equity owners of the RLEC. Our RLEC can also seek to rebalance rates periodically between various intrastate service categories, such as toll and access. Additionally, our RLEC has the ability to request relief on a dollar-for-dollar basis for certain events deemed outside of its control that result in reduced revenues or increased expenses. This may include changes in revenues that may result from portions of the interstate access charge reform. The Public Utility Commission is currently considering intrastate access reform for independent local exchange carriers in Pennsylvania. At this time, we are unable to predict the outcome of these developments on our results of operations or financial condition. The Public Utility Commission must also approve any issuance of stock, incurrence of long-term debt, or acquisition or sale of material utility assets by our RLEC. In addition, the Public Utility Commission must approve any change in control of either our RLEC or its holding company. The Public Utility Commission defines a "change in control" as either an acquisition or disposition of the largest single voting interest in a company, if that interest exceeds 20%. In addition, the FCC must also approve any sale or "transfer of control" of our RLEC or of its holding company. Our RLEC is subject to the jurisdiction of the Federal Communications Commission, or FCC, with respect to interstate rates, services, access charges and other matters, including the prescription of a uniform system of accounts. Interstate services, for the purpose of determining FCC jurisdiction, are communications that originate in one state and terminate in another state or foreign country, including the provision of access to local telephone networks for the origination or termination of such communications. Prices for our RLEC's interstate services, consisting primarily of subscriber line charges and access charges for interstate toll calls, which accounted for approximately 31.8% of our RLEC's 2002 revenues, are regulated by the FCC based on "average schedule" formulas that are designed to approximate the interstate jurisdictional costs of telephone companies based on statistical data rather than actual costs. These average schedule formulas are subject to periodic revision by the FCC and changes in the formulas, or removal of our RLEC from them, could result in a significant revenue loss. However, removal of our RLEC from these formulas is specifically listed in its Pennsylvania alternative regulation plan as an event outside of its control that would justify an offsetting rate adjustment. On November 9, 2001, the FCC released an order changing its interstate access charge rules and universal service support system for rate-of-return rural incumbent local exchange carriers. The new rules change the sources of funding under the average schedule formulas, but not the amounts paid to participants. These modifications include a reduction in access charges to long-distance companies, an increase in subscriber line charges to local service customers, and the creation of a universal funding mechanism funded by all telecommunications carriers. In addition to the above modifications, the FCC has also released a Notice of Proposed Rulemaking under which it will investigate the possibility of allowing telephone companies such as our RLEC to convert to a form of incentive regulation similar in some respects to its existing alternative regulation plan in Pennsylvania. We are unable to predict the outcome of this proposed rulemaking at this time. 21 CTSI The Pennsylvania Public Utility Commission exercises jurisdiction over intrastate service, including basic local exchange service, intrastate access services and intraLATA toll services. Under the Public Utility Commission's current practices, CTSI's rates and services are generally subject to much less regulatory scrutiny than those of the RLEC in its markets. Additionally, municipalities and other local government agencies may oversee CTSI's access to public rights-of-way. Under the Telecommunications Act of 1996, the Pennsylvania Public Utility Commission also has authority to arbitrate any disputes over the terms and conditions of interconnection between CTSI and Verizon, and the prices of various unbundled network elements CTSI purchases from Verizon. This Commission has taken a number of actions over the past several years affecting the prices for network elements, as well as the terms and conditions under which these elements are provided. Further decisions by this Commission may have a material effect on CTSI's costs and profitability. At the federal level, the Federal Communications Commission has jurisdiction over interstate services, including access charges as well as long-distance services. CTSI's rates, terms and conditions of service are filed with the FCC in tariffs and are subject to the FCC's complaint jurisdiction, and in the case of switched access service are subject to rate caps prescribed by the FCC, as described further below. In April 2001, the FCC released an order adopting new rules limiting the right of competitive local exchange carriers to collect reciprocal compensation on local telephone calls that terminate to Internet service providers. Under the new rules, which took effect on June 14, 2001, the amount of compensation payable by other local telephone companies to our RLEC edge-out operation on calls to Internet service providers will generally be limited to $0.0015 per minute for the first six months after the rules took effect, $0.0010 per minute for the next eighteen months and $0.0007 per minute thereafter. Any traffic exchanged between carriers that exceeds a three-to-one ratio of terminating to originating minutes is presumed to be traffic to Internet service providers, although either CTSI or the other telephone company may attempt to rebut this presumption and show a different level of Internet traffic. In addition, the number of minutes on which compensation is payable is limited by a formula based upon the number of compensable minutes exchanged in the first quarter of 2001. The rates under the new rules are substantially lower than the compensation CTSI was previously collecting in Pennsylvania, where the effective rates were as high as $0.0028 per minute. For the six months ended June 30, 2002, CTSI recorded approximately $5,974 or 14.2% of its edge-out revenues from revenue for calls terminated to Internet service providers. This compares to $4,304 or 12.3% for the corresponding period in the prior year. On May 3, 2002, the U.S. Court of Appeals for the D.C. Circuit remanded the FCC's order on reciprocal compensation for Internet traffic on the grounds that the FCC did not provide proper statutory authority for its order. The Court did not vacate the order and thus the current compensatory scheme will remain in effect pending the remand. However, should the FCC fail to satisfy the Court's demand for adequate statutory authority, the FCC's order would be vacated. The effect of such a vacation on CTSI's operations is currently unknown. Also in April 2001, the FCC released a separate order adopting new rules to limit the access charges of non-dominant providers. Under these rules which took effect on June 20, 2001, competitive carriers are required to reduce their interstate access charges to rates no higher than 2.5 cents per minute (CTSI's previous interstate access charges were as high as 4.5 cents per minute). After one year, this rate ceiling will be reduced to 1.8 cents and after two years to 1.2 cents per minute. After three years, CTSI will be required to charge rates no higher than the incumbent local exchange carrier (in our case, Verizon, which we expect will charge rates of approximately 0.45 cents per minute by 2004 as a result of an FCC plan requiring regional Bell operating companies to reduce their rates to this level). For the six months ended June 30, 2002, interstate access revenue accounted for approximately 5.7% of CTSI's "edge-out" market 22 revenue. This decision will result in substantial reductions in CTSI's billed access charges. On June 14, 2002 the U.S. Court of Appeals for the D.C. Circuit vacated the FCC's October 2001 Declaratory Ruling finding that interexchange carriers ("IXCs") must complete calls to and from customers of competitive local exchange carriers ("CLECs") that charge presumptively reasonable rates for interstate switched access service. This decision has created uncertainty concerning when IXCs may lawfully, if ever, decline to pay CLEC access charges while receiving CLEC access services. CTSI currently has agreements with two of the three largest IXCs for the termination of its calls. However, it has no such agreements with other IXCs and therefore the Court of Appeals' decision raises questions relating to these carriers' obligations to accept CTSI traffic. In addition, the Court's decision may lead to an invalidation of the CLEC Benchmark Access Charge Order by the D.C. Circuit on the same grounds (see above). On May 24, 2002, the U.S. Court of Appeals for the D.C. Circuit issued a decision remanding certain elements of the FCC's Local Competition Order relating to the provisioning of unbundled network elements ("UNEs") provided by incumbent local telephone companies to competitors such as CTSI. The FCC has requested that the full D.C. Court of Appeals rehear the case in light of the recent United States Supreme Court decision dealing with the FCC's UNE pricing regulation. However, should this decision stand, it could affect CTSI's access to unbundled network elements which are necessary to provide service to certain of its customers. Further decisions by the FCC may have a material effect on CTSI's costs and profitability. The FCC has recently begun reviews of several of its local competition policies that could result in changes to the interconnection arrangements on which our RLEC edge-out operation relies, or in additional competition from the incumbent local telephone companies. We cannot predict the outcome of these reviews, or of future rule changes that the FCC may initiate. PART II. OTHER INFORMATION Item 1. Legal Proceedings None Item 4. Submission of Matters to a Vote of Security Holders The Annual Meeting of Shareholders was held on May 8, 2002. Matters submitted to our shareholders included: 1) The election of the following Class III Directors to serve for a term of three (3) years: Nominee For Withheld ------- --------------------- James Q. Crowe 46,163,272 273,770 Michael A. Adams 46,163,272 273,770 Stuart E. Graham 46,163,272 273,770 Richard R. Jaros 46,163,272 273,770 Timothy J. Stoklosa 46,163,272 273,770 Additional Directors whose term of office as a Director continued after the meeting included: David C. McCourt Daniel E. Knowles Walter Scott, Jr. David C. Mitchell Michael J. Mahoney Frank M. Henry Eugene Roth, Esq. John J. Whyte 23 2) The ratification of the selection of PricewaterhouseCoopers LLP as our independent auditors for the year ending December 31, 2002. For Against Abstain --------------------------------------- 45,757,041 663,157 16,844 3) The approval of amendments to our Equity Incentive Plan. For Against Abstain --------------------------------------- 41,272,595 5,095,657 68,790 4) The approval of our updated Bonus Plan. For Against Abstain --------------------------------------- 44,129,233 2,216,288 91,521 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits (4) Instruments defining the rights of security holders, including indentures (a) Second amended and restated line of credit agreement dated as of June 4, 2002 by and between Commonwealth Telephone Company as borrower and CoBank, ACB. (10) Material Contracts (a) Amended CTE 1996 Equity Incentive Plan dated as of May 15, 2002. (b) Commonwealth Telephone Enterprises, Inc. Bonus Plan. (99) Additional Exhibits (a) Registrant's certification of periodic report. (b) Reports on Form 8-K None Item 7(a). Quantitative and Qualitative Disclosure about Market Risk Quantitative and Qualitative Disclosure about Market Risk - We are exposed to interest rate risk primarily through our borrowing activities. There is inherent rollover risk for borrowings as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and our future financing requirements. 24 The table that follows summarizes the fair values of our fixed and variable rate debt. The table also provides a sensitivity analysis of the estimated fair values of these financial instruments assuming 100-basis-point upward and downward shifts in the weighted average interest rate.
Fair value Fair value (thousands of dollars) assuming assuming Carrying +100 basis -100 basis As of June 30, 2002 amount Fair value point shift point shift ---------------------------------------------------------------------------------------------- Long-term debt and notes payable: Fixed $ 30,794 $ 32,530 $ 32,446 $ 32,615 Variable $ 160,021 $ 160,021 $ 158,181 $ 161,899
We manage our interest rate risk through a combination of variable and fixed rate debt instruments at varying maturities and by using interest rate swaps. The table below provides information about our interest rate swaps. Notional amounts are used to calculate the contractual payments to be exchanged under the contract. The estimated fair value amounts have been provided to us by the financial institutions with which we have swap contracts using appropriate and consistent valuation methodologies. (thousands of dollars) Approximate Maturity Notional fair value as of date Fixed rate amount June 30, 2002 ------------------------------------------------------- Variable to fixed: Hedge 3 2004/(a)/ 5.78% $20,000 $(1,072) Hedge 4 2002/(b)/ 6.13% $15,000 $ (953) Hedge 5 2002 6.36% $15,000 $ (171) Hedge 6 2006 5.40% $35,000 $(1,898) Hedge 7 2003 4.75% $20,000 $ (532) /(a)/ With an option by the counterparty to terminate the contract in 2002. /(b)/ Extendible to 2004 at the option of the counterparty. Two of our interest rate swaps matured in the second quarter 2002, and were not renewed. Additionally, two interest rate swaps are maturing in the third quarter 2002. One swap contains an option to extend, and we believe the counterparty will invoke this option. We will analyze market conditions as the maturity date approaches. As of August 14, 2002, we had no other material exposure to market risk. 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: August 14, 2002 Commonwealth Telephone Enterprises, Inc. /s/ Donald P. Cawley -------------------- Donald P. Cawley Senior Vice President and Chief Accounting Officer (Principal Financial Officer and Principal Accounting Officer) 26