10-K 1 hcc10k03.txt HECTOR COMM CORP FORM 10-K (12/31/03) -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 31, 2003 Commission File Number: 001-13891 HECTOR COMMUNICATIONS CORPORATION Minnesota 41-1666660 --------------------------------- ------------------- (State or other jurisdiction (Federal Employer of incorporation or organization) Identification No.) 211 South Main Street P.O. Box 428 Hector, MN 55342 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (320) 848-6611 Securities registered pursuant to Section 12(b) of the Act: Title of each class Common Stock, $.01 par value Securities registered pursuant to Section 12(g) of the Act: None 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 and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by a check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by a check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Act). Yes [ ] No [X] The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $54,586,000 based upon the closing sale price of the Company's common stock on the American Stock Exchange on March 22, 2004. As of March 22, 2004 there were outstanding 3,608,813 shares of the Registrant's common stock. Documents Incorporated by Reference: Portions of the Company's definitive proxy statement for its Annual Meeting of Shareholders to be held on May 20, 2004 are incorporated by reference into Part III of this Form 10-K. -------------------------------------------------------------------------------- TABLE OF CONTENTS Item Page PART I 1. Business 3 2. Properties 15 3. Legal Proceedings 15 4. Submission of Matters to a Vote of Security Holders 15 PART II 5. Market for Company's Common Equity and Related Stockholder Matters 16 6. Selected Financial Data 17 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 7A Quantitative and Qualitative Disclosures About Market Risk 26 8. Financial Statements and Supplementary Data 27 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 51 9A Controls and Procedures 51 PART III 10. Directors and Executive Officers of the Registrant 52 11. Executive Compensation 52 12. Security Ownership of Certain Beneficial Owners and Management 52 13. Certain Relationships and Related Transactions 52 14. Principal Accountant Fees and Services 52 PART IV 15. Exhibits, Financial Statement Schedule and Reports on Form 8-K 53 2 PART I. ITEM 1. BUSINESS [a] GENERAL DEVELOPMENT OF BUSINESS Hector Communications Corporation ("HCC" or "Company") is a telecommunications holding company which, through its wholly-owned subsidiaries, primarily provides local telephone, cable television and internet access services. The Company also participates in the ownership of other companies providing wireless telephone and other telecommunications related services. HCC operates five local exchange company subsidiaries (generally referred to as "local exchange carriers" or "LECs") which served 7,532 access lines in 9 rural communities in Minnesota and Wisconsin at December 31, 2003. HCC, through its wholly-owned subsidiaries, also provides cable television service or video service to 4,357 subscribers in Minnesota and Wisconsin. HCC's 100% owned subsidiary, Alliance Telecommunications Corporation ("Alliance"), owns and operates four additional LEC subsidiaries which served 22,350 access lines in 19 rural communities in Minnesota, Wisconsin and North Dakota at December 31, 2003. Alliance, through its subsidiaries, also served 4,752 cable television and video subscribers in Minnesota. Prior to July 7, 2003 Alliance Telecommunications Corporation ("Alliance") was 68% owned by HCC. ("Golden West") of Wall, South Dakota and Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota owned the remaining interests in Alliance. Effective July 7, 2003 Alliance was reorganized under Section 355 of the Internal Revenue Code ("the split-up transactions'). In the split-up transactions, Golden West exchanged its minority ownership interest in Alliance for all of the outstanding stock of Sioux Valley Telephone Company, which included a pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. ACCI exchanged its minority ownership interest in Alliance for all of the outstanding stock of Hills Telephone Company, which included a pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. HCC became the 100% owner of all remaining Alliance assets and operations. (See "Split-up of Alliance Telecommunications Corporation" in Item 7.) The disclosures in this report related to prior periods have been restated to reflect the Company's continuing operations. The Company maintains a website at www.hectorcom.com. Our Annual Reports on Form 10-K, our Quarterly Reports on Form 10-Q and our periodic reports on Form 8-K (and any amendments to these reports) are available free of charge by linking from our website to the Securities & Exchange Commission's website. [b] FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company is organized in two business segments, Hector Communications Corporation and its subsidiaries, and Alliance Telecommunications Corporation and its subsidiaries. Information regarding segment operations is provided in Note 13 to the financial statements found under Item 8 of this report. [c] NARRATIVE DESCRIPTION OF BUSINESS The Company derives the majority of its revenues from providing basic telephone services (often referred to as "plain old telephone service" or "POTS") to residential and business customers within its service territories. POTS revenues consist mainly of fees for local service which are billed directly to customers and access revenues which are received for intrastate and interstate exchange services provided to long distance carriers. POTS revenues are subject to regulation by a number of state and federal government agencies. The Company also earns revenues by providing a number of nonregulated telecommunications services to customers. These services include cable television or video service, internet access services, lease of fiber optic transport facilities, billing and collection services to long distance carriers, telephone directory services, engineering services and equipment rental. The Company also makes retail sales of consumer telecommunications equipment and sells wireless telephone services on a commission basis. 3 The following table presents the percentage of revenues derived from local service revenues, access revenues, nonregulated telecommunications activities and cable television operations for the last three years: Year Ended December 31 ---------------------------------------- 2003 2002 2001 ------ ------ ------ Local network 18.9% 19.3% 18.0% Network access 49.7 50.1 51.2 Video services 11.1 12.1 11.4 Internet services 8.2 6.4 5.1 Other nonregulated services 12.1 12.1 14.3 ------ ------ ------ 100.0% 100.0% 100.0% ====== ====== ====== The Company also owns minority interests in joint ventures, partnerships and limited liability corporations ("LLCs") that provide a wide variety of telecommunications services, including wireless telephone services, fiber-optic transport services and telephone switching services. The Company's most significant minority ownership position is its 8% interest in Midwest Wireless Holdings LLC. (1) Plain Old Telephone Service ("POTS") Local Network ------------- The Company's LEC subsidiaries provide basic local telephone services to residential and business customers in Minnesota, Wisconsin and North Dakota. Local service revenues are earned by providing customers with local service to connecting points within the local exchange boundaries and, in certain cases, to nearby local exchanges under extended area service ("EAS") plans that eliminate long distance charges to the neighboring exchanges. Monthly rates for telephone service differ among the LECs depending upon the cost of providing service, the type and grade of service, the number of customers and calling patterns within the toll free calling area and other factors. The following chart presents the number of access lines served by the Company's LEC subsidiaries at December 31, 2003, 2002 and 2001: Access Lines* -------------------------------- December 31 -------------------------------- 2003 2002 2001 ------ ------- ------ Hector Communications Corporation: Arrowhead Communications Corporation 804 806 808 Eagle Valley Telephone Company 719 747 727 Granada Telephone Company 287 296 289 Pine Island Telephone Company 3,339 3,368 3,313 Indianhead Telephone Company 2,383 2,403 2,392 ------ ------ ------ Total Hector Access Lines 7,532 7,620 7,529 ------ ------ ------ Alliance Telecommunications Corporation: Loretel Systems, Inc. 13,253 13,286 13,300 Sleepy Eye Telephone Company 6,298 6,503 6,556 Felton Telephone Company 732 765 752 Hager TeleCom, Inc. 2,067 2,061 2,037 ------ ------ ------ Total Alliance Access Lines 22,350 22,615 22,645 ------ ------ ------ Total Access Lines 29,882 30,235 30,174 ====== ====== ====== * An "access line" is a single or multi-party circuit between the customer's establishment and the central switching office. The Company's LEC subsidiaries offer their customers a number of enhanced telecommunications services, including custom calling features like call waiting, caller identification and voice mail. Charges for custom calling services are generally billed monthly together with the customers' local service bill. The Company maintains a local presence in each of its LEC subsidiaries. The Company provides its LEC subsidiaries with various services, including 4 finance, accounting and treasury services, marketing, customer service, purchasing, engineering and construction, customer billing, rate administration, credit and collection, and development of administrative and procedural practices. Access Revenues --------------- Access revenues are received by LECs for intrastate and interstate exchange services provided to long distance carriers (generally referred to as interexchange carriers or "IXCs"). These services enable IXCs to provide long distance service to end users in the local exchange network. Access revenues are determined, in the case of interstate calls, according to rules promulgated by the Federal Communications Commission ("FCC") and administered by the National Exchange Carriers Association ("NECA"). In the case of intrastate calls, access revenues are determined by state regulatory agencies. In 2003, approximately 70% of the Company's access revenues were from interstate sources and 30% were from intrastate sources. A portion of the Company's interstate access revenue is derived from subscriber line charges ("SLCs") determined by the FCC and billed directly to end users for access to long distance carriers. Another portion consists of universal service funds received based upon the high cost of providing service to rural areas. The balance of the interstate access revenue is received from NECA, which collects payments from IXCs and distributes settlement payments to LECs. Settlement payments are based on a number of factors, including the cost of providing service and the amount of time the local network is utilized to provide long distance services. Through the 1980s and 1990s a variety of factors, including increased subscriber counts, cultural and technological changes, and rate reductions by IXCs, resulted in a consistent pattern of increasing use of the nation's telephone network. This growth produced higher revenues for NECA and increased settlements for its participating LECs. Intrastate access revenues are received from long distance carriers based on recorded customer usage multiplied by the appropriate tariff rate. Where applicable, HCC's LECs participate in intrastate access tariffs approved by state regulatory authorities for intrastate intra-LATA (Local Access Transport Area) and inter-LATA services. These intrastate arrangements are intended to compensate LECs for the costs, including a fair rate of return, of facilities provided in originating and terminating intrastate long distance services. (2) Nonregulated Telecommunications Activities Video services -------------- The Company, through its cable television and LEC subsidiaries, provide cable television services to 9,109 subscribers in Minnesota and the surrounding states. Video service revenues are derived almost exclusively from monthly fees for basic and premium programming. Fees for basic services range from $9.00 to $44.85 per month. Basic service generally includes the major television networks, non-network independent stations, sports programming, news services and automated information channels, children's programming, access channels for public, governmental, educational and leased use, senior citizens' programming and religious programming. Premium programming services, such as the HBO or ShowTime movie services, are provided to subscribers for an additional fee of $1.75 to $11.00 per month per channel. Premium programming is obtained from suppliers for a flat monthly fee per subscriber and/or a fee based on the monthly charge to subscribers for the service. In 2001 and 2002 the Company deployed broadband equipment manufactured by Next Level Communications, Inc. in its exchanges serving Pine Island, MN, Goodhue, MN and Sleepy Eye, MN. This equipment makes it possible to deliver POTS, video and high speed Internet services to the customer over the same circuit. Video programming is delivered utilizing a digital "super headend" owned by Broadband Visions, LLC, in which the Company is an investor. The Company is planning to install broadband equipment in additional exchanges in future years. The Company's broadband product offerings are dependent on the availability of equipment from Next Level Communications, Inc. If the Company cannot obtain necessary equipment it could have a material adverse affect on its operations. 5 Internet -------- Revenues from internet services were $2,647,000, $1,945,000 and $1,591,000 in 2003, 2002 and 2001, respectively. Internet access is available, through local dial-up telephone numbers, to all of the Company's local service customers. Digital subscriber lines ("DSL") permit high-speed Internet access and are available in many of the Company's service areas. The Company provided dial-up internet services to 7,464, 7,558 and 7,217 customers at December 31, 2003, 2002 and 2001 respectively. The Company provided DSL services to 2,778, 1,601 and 709 customers at December 31, 2003, 2002 and 2001, respectively. Nearly two-thirds of the Company's DSL subscribers are in the Pine Island, Sleepy Eye and Goodhue exchanges where service is available utilizing Next Level equipment. Other services -------------- HCC's LECs provide fiber optic transport facilities, sell and lease customer premise telephone equipment, provide inside wiring services and sell and lease other facilities for private line, teletype, data transmission and other communications services. They also provide billing and collection services for certain IXCs in lieu of such IXCs directly billing customers within the LEC's service areas. Due to changes in market conditions the Company renegotiated several of its fiber leases in 2001 and 2003, resulting in a significant decline in lease revenue. All of the fiber-optic facilities leased are owned by HCC's LEC subsidiaries and are located within the LEC's local exchange boundaries. HCC's revenues from other nonregulated services were as follows: 2003 2002 2001 ----------- ----------- ----------- Fiber leases $ 682,521 $ 800,039 $ 1,136,612 Engineering fees 305,423 438,534 464,807 Directory 491,902 404,136 426,250 Billing and collection 212,622 289,723 409,557 Retail sales 522,269 346,508 540,595 Cellular sales commissions 316,337 333,714 300,146 Resale of long distance service 381,825 250,937 214,385 Equipment rent 118,292 62,457 91,696 Other 871,816 768,456 861,564 ----------- ----------- ----------- $ 3,903,007 $ 3,694,504 $ 4,445,612 =========== =========== =========== (3) Unconsolidated Affiliates and Investments Midwest Wireless Holdings LLC ----------------------------- Midwest Wireless Holdings LLC ("Midwest Wireless") provides wireless telecommunications services to 357,000 customers in fourteen rural service areas and one metropolitan service area in Minnesota, Wisconsin and Iowa. Population of the service areas is approximately 1,910,000. Midwest Wireless offers a complete package of services, including custom calling features, facsimile and data transmission. Midwest Wireless is owned by telecommunications companies (principally ILECs) located within Midwest Wireless' operating footprint in southern Minnesota, northern Iowa and southeastern Wisconsin. HCC is presently the second largest member of Midwest Wireless Holdings LLC, with an 8.0% ownership stake. HCC actively participates in Midwest Wireless' operations and has had a seat on the Board of Directors since the inception of the Company. HCC influences Midwest Wireless policies and procedures applying to administration, planning and budgeting, cell siting, technology selection, roaming agreements, affiliation agreements, marketing and customer service, financing, accounting policies and financial reporting and disclosure policies and the timing of financial reports. HCC accounts for its investment in Midwest Wireless using the equity method. Income recognized was $2,148,000, $2,261,000 and $1,153,000 in 2003, 2002 and 2001, respectively. Fiber-Optic Transport Investments --------------------------------- The Company is an investor in three companies that build and lease fiber- optic transport facilities. These facilities afford high-quality, high-capacity communications links and generally are used to carry long-distance traffic. Through these investments, the Company owns pieces of fiber routes serving the Twin Cities, Milwaukee, Madison, Duluth-Superior, Sioux Falls, Fargo-Moorhead, Rochester, St. Cloud and Grand Forks. 6 Other Investments ----------------- The Company is an investor in 702 Communications, a CLEC providing telecommunications services in the Fargo-Moorhead area, Wahpeton, ND and Breckinridge MN. The Company is also an investor in Desktop Media, Inc., a CLEC using a network employing ethernet architecture to provide telecommunications services in southeastern Minnesota. Wireless North, LLC ------------------- The Company was a 10.4% owner of Wireless North, which provided personal communications services ("PCS") to parts of Minnesota, Wisconsin, Iowa, North Dakota and South Dakota. Wireless North was unsuccessful and has been liquidated. Its licenses and systems were sold to other operators, or were shut down. In 2001, the Company made payments to Wireless North's primary lender of $1,129,000 to satisfy loan guarantees it gave with respect to Wireless North's debt. Cash investments in Wireless North by the Company totaled $3,202,000. The Company has written off its entire investment in Wireless North, has no obligation to provide additional funding and does not expect to realize any additional value from this investment. (4) Other Investments Bank Stocks ----------- As part of its borrowing agreements, the Company has investments in CoBank, Rural Telephone Finance Cooperative and the Rural Telephone Bank that totaled $3,609,000 and $5,241,000 at December 31, 2003 and 2002 respectively. Onvoy, Inc. ----------- Onvoy, Inc. is a privately held company that provides integrated voice, data, and network services through its fiber optic communications network linking communities throughout Minnesota, including all major metropolitan areas. Onvoy, Inc. is a provider of Internet, long distance, video-conferencing and high-speed data networking services. Onvoy's customers include Minnesota based Fortune 500 companies and many small-to-medium sized businesses. Onvoy also serves the state's higher education institutions, the state's K-12 schools, public libraries, state and county governments, more than 70 regional Internet service providers and the state's independent local telephone companies. During 2001 the Company purchased $190,000 of debt issued by Onvoy to provide additional working capital to Onvoy's operations. At December 31, 2003, the Company's investment in Onvoy debt totaled $626,000. Other long-term investments --------------------------- The Company has long-term investments in Independent Information Services Corp. and NECA, Inc., which it accounts for using the cost method. The Company also has receivables from economic development loans made through the Rural Utilities Service and has other small investments. (5) Competition Telephone Service LECs are subject to many forms of competition. Its competitors principally are: - Facilities-based competition from providers, including cable television service providers, with their own local service network; - Resale competition from resale interconnection (providers who purchase local services from the LEC at wholesale rates and resell the services to their customers); - Competition from unbundled network element interconnection (providers who lease some of the network elements from the LEC) - Wireless providers who may charge a competitive fee for services that could compete with wireline based local service. 7 Rural areas like those served by the Company are less likely to experience competition from facilities-based competitors due to the significant investment in plant and equipment required in relation to the lower customer density in rural markets. Competition from resale interconnection or unbundled network element interconnection is more likely. Under the Telecommunications Act of 1996, (the "Telecommunications Act") the Company's LECs are not currently required to lease facilities to competitors seeking to interconnect with its networks. However, there is no assurance that interconnection may not be required in the future. Wireless service has always competed directly with wireline local service among certain classes of customers, principally customers with seasonal or lake homes. Newer wireless service offerings that bundle local and long distance minutes for a flat fee are competing with wireline services over a broader class of customers. These wireless service offerings can be particularly attractive in rural areas, where the toll free dialing areas offered by wireline carriers are usually quite small. The Company believes that significant numbers of long distance minutes are migrating from the wireline to the wireless network due to these rate plans. This drives down the revenues of IXCs and reduces the Company's access revenues. Developments in technology related to cellular, PCS, digital microwave, coaxial cable, fiber optics and other wireline or wireless services could also lead to greater competition for traditional local services. LECs are increasingly subject to competition from competing access providers ("CAPs") which construct, modify or lease facilities that enable high volume long distance users to bypass the local telephone network. Cable television companies may also be able to modify their networks to carry telephone messages that bypass the local telephone network. The Company believes its LEC subsidiaries have experienced only a small loss of traffic due to bypass. Video Services In addition to competition from off-air television, other technologies also supply services that compete with cable television. These include low power television stations, multi-point distribution systems, over-the-air subscription television and direct broadcast satellite ("DBS"). Cable television also competes for customers in local markets with providers of other forms of entertainment, news and information. These competitors include radio, newspapers, magazines, motion picture theaters, video cassettes and Internet service providers. All of the Company's cable television franchises are non-exclusive. The 1992 Cable Act prohibits franchising authorities from unreasonably refusing to grant franchises to competing cable television systems. The Company competes with a municipally owned cable system in one community it serves. It also competes with a much larger multi-system operator in Sleepy Eye, where the Company is using broadband equipment to deliver video services. The degree of competition from other cable providers will be dependent upon the state and federal regulations concerning entry, interconnection requirements and the degree of unbundling of the LECs' networks. The Company expects to compete based upon product, service quality, breadth of services offered and, to a lesser extent, on price. Maintaining and expanding the Company's subscriber base depends on numerous factors, including the quality and quantity of signals available from "off-air" television stations, demand for satellite and premium television channels and average household income in the service area. Promotional efforts for video services include telephone and door-to-door selling and local media advertising. (6) Regulation The Company's LECs and cable television systems are subject to federal, state and local regulation. The Communications Act of 1934 and the Telecommunications Act govern Federal regulations. Under these federal statutes, the FCC exercises jurisdiction over all interstate telecommunications activities. Intrastate activities are governed by rules and regulations set by the respective state public utility commissions. 8 Federal Regulations ------------------- Under federal regulations, incumbent local exchange carriers ("ILECs") are required to comply with the Communications Act of 1934 and rules issued by the FCC. While the Telecommunications Act of 1996 amended the earlier law to reduce regulatory burdens and promote competition, ILECs remain subject to extensive regulatory requirements. ILECs are required to maintain accounting records according to Uniform System of Accounts, to structure access charges according to FCC rules and to reflect their charges for interstate services at a rate of return prescribed by the FCC. The FCC also regulates transfer of control and assignments of operating authorizations and construction licenses. The FCC requires carriers providing access services to file tariffs with the FCC reflecting rates, terms and conditions of the services. Tariffs filed are subject to review and potential objection by third parties. Regulation of Cost Recovery and Nonregulated Revenue Allocation As a regulated common carrier, the Company's LEC subsidiaries can set maximum rates at a level that allows recovery of reasonable costs incurred to provide regulated service and earns a reasonable return on the investment required to provide these services. Costs are recovered through: - Monthly charges to end users for basic local telephone services and enhanced services; - Access charges to interexchange carriers for originating and terminating interstate and intrastate interexchange calls; and - Payments from the federal Universal Service Fund and the state universal service funds (where applicable) that offset the high cost of providing service in certain rural markets. Rates for regulated services and the amount of universal service fund support are set forth by the FCC with respect to interstate services and by state regulatory agencies with respect to intrastate services. In conjunction with the recovery of costs and establishment of rates, a LEC must first determine its aggregate costs and then allocate those costs between regulated and nonregulated services. After identifying the regulated costs of providing local telephone service, a LEC must allocate those costs among its various local exchange and interstate and intrastate interexchange services and between state and federal jurisdictions. Allocating costs is complicated because the same pieces of a LEC's plant and equipment are utilized for different services, such as local telephone and interstate and intrastate access services. The allocation process is called "separation" and is governed primarily by FCC regulations. The purpose of separation is to determine how a carrier's expenses are allocated and recovered from federal and state jurisdictions. The FCC is considering whether to change or eliminate this process. Any change in separation rules by the FCC could reduce or increase the LEC's revenues. However, at this time it is not possible to predict what changes, if any, may be made. Interstate End-User Rates The part of the local telephone network running from the switching facility to the customer is called the "local loop." Costs to construct, operate and maintain the loop are among the most significant costs incurred by a local exchange carrier. In 1984 the FCC established a rate structure that provides for the recovery of a portion of the cost of the local loop allocated to interstate jurisdiction directly from end-users through the assessment of a subscriber line charge. The SLC was increased in 1989 to a $3.50 cap on residence and single line business lines and a $6.00 cap on multi-line business lines. The remaining portions of the interstate local loop costs were recovered from interstate access charges to interexchange carriers. In November 2001 the FCC adopted access charge reforms based in part on a proposal by the Multi-Association Group (the "MAG Plan"). The MAG Plan increases the maximum rate caps for SLCs as follows: Residential and Single Line Business January 1, 2002 Increase from $3.50 to $5.00 July 1, 2002 Increase from $5.00 to $6.00 July 1, 2003 Increase from $6.00 to $6.50 Multi-line Business January 1, 2002 Increase from $6.00 to $9.20 9 The increased SLC revenues are offset by reductions in recovery of local loop costs from interexchange carriers. The plan is intended to be revenue neutral for affected LECs. Due to demographic and geographic conditions, costs to provide local loop and switching services are often higher, on a per customer basis, in rural areas compared to urban areas. Absent a regulatory framework to permit recovery of these costs, rural LECs would be compelled to charge considerably higher rates for local network services. Consequently, the FCC provides for additional interstate recovery by eligible telecommunications carriers through the federal Universal Service Fund. Funds from the federal Universal Service Fund are available to local exchange carriers whose local loop costs are significantly above the national average as determined by FCC rules. Interstate universal service fund support accounted for $1,879,000, $1,458,000 and $1,412,000 of the Company's network access revenues in 2003, 2002 and 2001, respectively. Interstate Access Rates ----------------------- Interstate access rates are developed on the basis of a LEC's measurement of its interstate costs to provide access service to IXCs divided by its projected demand for service. The resulting rates are published in the LEC's interstate access tariff and filed with the FCC, at which time they are subject to challenge by third parties and to review by the FCC. The FCC recognized that the rate making and tariff filing process is administratively burdensome for small local exchange carriers. In 1983, the FCC established the National Exchange Carriers Association ("NECA") to develop and administer interstate access service rates, terms and conditions. NECA develops interstate access rates on the basis of data provided by participating local exchange carriers and blended to yield average rates. These rates are intended to generate revenue equal to the aggregate costs plus a return on the investment of all of the participants. Individual LECs are likely to have service costs that differ from the revenues generated by applying the overall NECA tariff rates. To allow for this, revenues generated by participating LECs are pooled and redistributed on the basis of each individual company's costs. This process eliminates the burden of individual tariff filing and produces a system in which small companies can share and spread risk. For example, if a small local exchange carrier filed its own tariff and subsequently suffered the loss of major customers that utilize interstate access service, the local exchange carrier could suffer significant under-recovery of its costs. In the NECA pool environment, the impact of this loss is reduced because it is spread over all of the pool participants. NECA operates separate pools for traffic sensitive costs (primarily switching costs) and non-traffic sensitive costs (primarily loop costs). LECs can choose to develop and administer their own interstate access charges and not participate in the NECA pools. All of HCC's LECs participate in the traffic sensitive and non-traffic sensitive NECA pools. The FCC is reviewing its rates and policies governing interstate access and the rate of return applicable to incumbent local exchange carriers who are subject to rate-of-return, rather than price cap, regulation. The outcome of this review could directly affect HCC's earnings, however, the outcome of this proceeding cannot be predicted at this time. The Telecommunications Act -------------------------- The Telecommunications Act was enacted to promote competition without jeopardizing the availability of nationwide universal service at affordable rates. These two objectives have resulted in a complex set of rules intended to promote competitive entry in the provision of local telephone services, except where entry would adversely effect the provision of universal service or the public interest. 10 Promotion of Local Service Competition and the Rural Exemptions --------------------------------------------------------------- The Telecommunications Act made competitive entry into the local telephone business more attractive to other carriers by removing barriers to competition. In order to promote competition the Telecommunications Act established new interconnection rules generally requiring local exchange carriers to allow competing carriers to interconnect with their local networks. Congress recognized, however, that the desire to promote competition conflicted with the ability of some existing LECs to provide universal service to high cost customers. Congress exempted these LECs (classified as "Rural Telephone Companies") from interconnection requirements until the continuation of the exemption was no longer in the public interest, as defined in the Telecommunications Act. Under the Telecommunications Act, all local exchange carriers, including both incumbent local exchange carriers and new competitive carriers, are required to: - Offer reasonable and nondiscriminatory resale of their telecommunications services, - Ensure that customers can keep their telephone numbers when changing carriers, - Ensure that competitors' customers can use the same number of digits when dialing and receive nondiscriminatory access to telephone numbers, operator service, directory assistance and directory listing, - Ensure access to telephone poles, ducts, conduits and rights of way and - Compensate competitors for the costs of terminating traffic. The Telecommunications Act also requires incumbent local exchange carriers to: - Negotiate in good faith the terms and conditions of interconnection with any competitive carrier making a bona fide request for same, - Interconnect their facilities and equipment with any requesting telecommunications carrier at any technically feasible point, - Unbundle and provide nondiscriminatory access to unbundled network elements, such as local loops, switches and transport facilities, at nondiscriminatory rates and on nondiscriminatory terms and conditions, - Offer resale interconnection at wholesale rates, - Provide reasonable notice of changes in the information necessary for transmission and routing of services over the incumbent local exchange carrier's facilities or in the information necessary for interoperability and - Provide for the physical collocation of equipment necessary for interconnection or access to unbundled network elements at the premises of the incumbent local exchange carrier, at rates, terms and conditions that are just, reasonable and nondiscriminatory. In order to implement interconnection requirements, local exchange carriers generally enter into negotiated interconnection arrangements with competing carriers. Local exchange carriers may also offer interconnection tariffs, available to all competitors. Competitors are required to compensate a local exchange carrier for the cost of providing interconnection services. In the case of resale interconnection, the rules provide that the rates charged should be on a wholesale basis and reflect the current retail rates of the incumbent local exchange carrier, excluding the portion of costs avoided by the incumbent local exchange carrier. In the case of unbundled network element interconnection, rates are based on costing methodologies that employ a forward-looking economic cost pricing methodology known as total element long run incremental cost. The Telecommunications Act specifies that resale and unbundled network element rates are to be negotiated among the parties, or, if the parties fail to reach an agreement, arbitrated by the relevant state regulatory authority. Once the parties have come to agreement, the proposed rates are subject to final approval by the state regulatory commission. 11 The Company's LEC subsidiaries are defined as "rural telephone companies" under the Telecommunications Act. As rural telephone companies, they were granted rural exemptions from the requirements relating to both resale interconnection and unbundled network element interconnections. The rural exemptions are continued until regulatory authorities determine that interconnection is technically feasible, not unduly economically burdensome and consistent with the Telecommunications Act's universal service provisions. Promotion of Universal Service ------------------------------ While the Telecommunications Act promoted Congress' policy of ensuring that affordable service is provided to consumers universally in rural, high-cost areas of the country, the Telecommunications Act altered the framework for providing universal service by: - Providing for the identification of those services eligible for universal service support, - Requiring the FCC to make implicit subsidies explicit, - Expanding the types of communications carriers required to pay universal service support and - Allowing competitive local exchange carriers to be eligible for funding. These and other provisions were intended to make provision of universal service support compatible with a competitive market. Pursuant to the Telecommunications Act, federal Universal Service Fund payments are only available to carriers that are designated as eligible telecommunications carriers ("ETC") by a state public utilities commission. In areas served by rural LECs, the Telecommunications Act provides that a state public utilities commission may designate more than one eligible telecommunications carrier, in addition to the incumbent local exchange carrier, only after determining that the designation of an additional eligible telecommunications carrier will serve the public interest. Wireless providers have received ETC designation in Company served areas in North Dakota and Iowa, and have applied for ETC designation in Minnesota. The addition of a second eligible telecommunications carrier in these service areas could have the effect of reducing the amount of funds available to HCC's LECs from the federal Universal Service Fund. Such a reduction could materially adversely affect HCC's ability to achieve a reasonable rate of return on the capital invested in its network. State Regulation of Rural LECs ------------------------------ HCC's LEC subsidiaries are subject to regulation by Minnesota, North Dakota and Wisconsin regulatory agencies with respect to: - Intrastate toll rates, - Intrastate access charges billed to intrastate IXCs, - Service areas, - Service standards, - Accounting and related matters, and - The use of radio frequencies in telephone operations In some cases state regulations also apply to local service rates, rate of return, depreciation rates, construction plans and borrowings, and certain other financial transactions. Local service rates are not directly determined by regulatory authorities, but are limited by regulation of these other areas. The Company has sought appropriate increases in local and other service rates and approval for changes in rate structures necessary to achieve reasonable rates and earnings. The bulk of the Company's access lines are located in Minnesota. A bill passed by the 1995 Minnesota legislature allows telephone companies serving fewer than 50,000 access lines to elect to provide service under an alternate form of regulation. Companies choosing alternative regulation agreed not to increase rates for two years, other than in extraordinary circumstances. These 12 companies are not subject to rate of return review by the Public Utilities Commission for the same two years. All of HCC's Minnesota-based LEC subsidiaries (except Felton Telephone Company) elected alternative rate regulation election effective January 1, 1996. Local rate increases after January 1, 1998 are not subject to review by the Minnesota Public Utilities Commission unless the lower of 500 or five percent of customers file a petition requesting such review. In 2001, the Company increased its local service rate for Sleepy Eye Telephone Company. The commission did not review the rate increase. The Minnesota Public Utilities Commission is investigating intrastate access rates charged by local telephone companies to IXCs. The commission has proposed a plan reducing intrastate access charges and implementing a state universal service fund to compensate high cost companies. The Company cannot predict the outcome of the rate investigation or if any part of the proposed plan will be adopted. Cable Television System Regulation ---------------------------------- The FCC regulates the providers of satellite communications services and facilities for the transmission of programming services, the cable television systems that carry such services, and, to some extent, the availability of the programming services themselves through its regulation of program licensing. Municipalities and other state and local government authorities also regulate cable television systems. FCC regulations contain many detailed provisions including: - "Must carry" rules regarding the broadcast television and translator signals that must be included in channel offerings to subscribers, - Exclusivity provisions which require the deletion of certain programming carried by out-of-area stations where it would duplicate programming carried by local stations, - Technical standards and performance testing requirements, and - Franchise fees applicable to state and local cable television franchises. Thus far, HCC's cable systems have not experienced any difficulty in complying with the FCC rules. In Minnesota, the award of cable franchises and certain aspects of cable operations are subject to rules of the Minnesota Cable Communications Board. Cable television systems are operated under 15 year, non-exclusive franchises granted by local government authorities. Franchises contain many conditions, including time limitations on commencement or completion of construction, approval of initial fees charged to subscribers for basic service, the number of channels offered and the types of programming. HCC does not anticipate difficulty in obtaining renewal of its franchises at the expiration of their current terms. The regulation of cable television at the federal, state and local levels is subject to the political process and has been in constant flux over the past decade. This process continues in the context of legislative proposals for new laws and the adoption or deletion of administrative regulations and policies. The Company anticipates further material developments in these areas, but cannot anticipate their direction and impact on its cable television operations. (7) Business Strategy The Company is focused on business opportunities in rural telecommunications. Its three-part strategy is to: - Expand its existing operations through internal growth - Pursue acquisitions of attractive properties, particularly the acquisition of additional rural telephone exchanges and cable television properties - Participate in opportunities afforded by new telecommunications technologies Future growth in existing telephone and cable operations is expected to come from providing service to new or presently unserved homes and businesses, from sales of enhanced services to existing customers and from providing new services made possible by improvements in technology. 13 The Company continually assesses possible acquisition opportunities. Competition to acquire attractive telephone or cable television properties is intense. Acquisitions of rural telephone exchanges are subject to the approval of regulatory agencies in some states and, in some cases, to federal waivers that may affect the form of regulation or amount of interstate cost recovery of acquired telephone exchanges. The Company will aggressively pursue acquisitions of telephone exchanges, but there is no assurance that acquisitions can be made on acceptable terms or that regulatory approval, where required, will be received. The Company has aggressively invested in new telecommunications technologies, primarily through investments in partnerships and limited liability companies. The Company has substantial investments in wireless communications companies, fiber optic transport groups, CLECs and Internet service providers. The Company intends to pursue additional investment opportunities in the future. (8) Employees At March 1, 2004, the Company had 146 full-time and part-time employees, of which 86 employees work in the Alliance operations and 60 work in Hector operations. None of the Company's employees are represented under collective bargaining agreements. HCC believes its employee relations to be good. (9) Executive Officers of Registrant The executive officers of the Company and their ages at March 1, 2004 were as follows: Name Age Position ----------------- --- ------------------------------- Curtis A. Sampson 70 Chairman of the Board and Chief Executive Officer Steven H. Sjogren 61 President and Chief Operating Officer Paul N. Hanson 57 Vice President and Treasurer Charles A. Braun 46 Chief Financial Officer Executive officers serve at the pleasure of the Board of Directors and are elected annually for one-year terms. Each officer above has served the Company in the indicated capacity since 1990. Mr. Sjogren devotes his full time to the Company's business. Messrs. Sampson, Hanson and Braun devote approximately 50%, 50% and 80% respectively of their working time to the Company's business with the balance devoted to management responsibilities at Communications Systems, Inc. ("CSI"), a diversified telecommunications holding company also located in Hector, Minnesota, for which they are separately compensated by CSI. [d] FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Not Applicable. 14 ITEM 2. PROPERTIES The Company's telephone property consists mainly of central office switching equipment, the land and buildings in which the equipment is housed, and connecting lines consisting of aerial and underground cable, conduit, and poles and wires which connect customers' premises with central offices. Connecting lines are generally located under or above public rights of way or land owned, for the most part, by others, pursuant to consents of various governmental bodies or private leases, permits, easements, agreements or licenses. The Company also owns customer-leased telephones and related terminal equipment and a small amount of connecting lines that are located on customers' premises. The connecting lines constitute approximately 52% of the Company's telephone property in service. Central office switching equipment represents approximately 32%. Telephones, customer premise broadband equipment and related equipment constitute approximately 2%. Land, buildings, data processing equipment, service vehicles and construction equipment constitute the remaining 14%. The Company owns substantially all the land and buildings in which its central office equipment is located. HCC's principal general offices, administrative services department and business office are located in Hector, Minnesota and are rented by HCC from CSI. The physical assets of the Company's cable television systems consist of signal reception equipment and distribution electronics and cables. The receiving equipment is comprised of a tower and antennas for reception of broadcast television signals and one or more satellite dishes for reception of satellite signals. The Company owns or leases the land on which the towers for its cable systems and the buildings containing other receiving equipment are located. Pole attachment space is rented from utilities serving the community. See Note 9 of "Notes to Consolidated Financial Statements" for additional information regarding pledged assets. ITEM 3. LEGAL PROCEEDINGS No material litigation or other claims are presently pending against the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 15 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS [a] MARKET INFORMATION The Company's common stock is traded on the American Stock Exchange ("AMEX"). The table below presents the range of high and low trading prices for the Company's stock for each period as reported by AMEX: 2003 2002 ------------------ ------------------ Quarter High Low High Low ------- ------- ------- ------- First $ 13.60 $ 11.80 $ 16.95 $ 12.50 Second 13.89 11.50 14.85 11.62 Third 14.35 12.45 11.90 9.00 Fourth 14.14 13.06 12.65 8.90 [b] HOLDERS At March 1, 2004 there were 511 holders of record of Hector Communications Corporation common stock. [c] DIVIDENDS HCC has not paid cash dividends on its common stock or preferred stock since it began operating as a public company in 1990, nor does HCC have any obligation to pay dividends on its preferred stock. The financing agreements between HCC's subsidiaries and their lenders, and HCC and its lenders restrict the ability of HCC to pay dividends. At the present time, HCC intends to retain earnings to finance the expansion of its business, and does not anticipate any cash dividends will be paid in the foreseeable future. See Management's Discussion and Analysis of Financial Condition and Results of Operations, and also Note 9 to the Consolidated Financial Statements under Item 8 herein for a description of restrictions on dividends. [d] OTHER INFORMATION REGARDING EQUITY COMPENSATION PLANS The following table presents information about our equity compensation plans as of December 31, 2003:
Securities Authorized For Issuance Under Equity Compensations Plans (a) (b) (c) Number of shares of Number of shares of common stock remaining common stock to be available for future issued upon exercise Weighted-average issuance under equity of outstanding exercise price of compensation plans options, warrants and outstanding options, (excluding shares in Plan Category (1) rights warrants and rights column (a)) ----------------- --------------------- -------------------- ---------------------- Equity compensation plans approved by security holders: 1990 Stock Plan 148,100 $ 10.86 - 1999 Stock Plan 323,217 $ 11.97 273,833 2003 Employee Stock Purchase Plan 12,369 11.92 87,631 Equity compensation plans not approved by security holders: None (1) The Company does not have individual compensation arrangements involving the granting of options, warrants and rights.
16 ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL INFORMATION (in thousands except per share amounts) Year Ended December 31 ------------------------------------------------------------- 2003 2002 2001 2000 1999 --------------------------------------------------------------------------------------------------------------------------------- Selected Income Statement Information Revenues from Continuing Operations $ 32,322 $ 30,517 $ 31,073 $ 29,067 $ 25,747 Costs and Expenses 24,365 23,875 24,404 21,913 18,400 --------------------------------------------------------------------------------------------------------------------------------- Operating Income from Continuing Operations 7,957 6,642 6,669 7,154 7,347 Other Income (Expenses), net 316 (1,053) 1,752 (1,539) 8,664 --------------------------------------------------------------------------------------------------------------------------------- Income from Continuing Operations Before Income Taxes and Minority Interest 8,273 5,589 8,421 5,615 16,011 Income Tax Expense 3,316 2,483 4,162 3,155 6,682 --------------------------------------------------------------------------------------------------------------------------------- Income from Continuing Operations Before Minority Interest 4,957 3,106 4,259 2,460 9,329 Minority Interest in Earnings of Alliance Telecommunications Corporation 660 782 1,078 411 2,947 --------------------------------------------------------------------------------------------------------------------------------- Income from Continuing Operations 4,297 2,324 3,181 2,049 6,382 Income from Discontinued Operations 882 1,331 1,435 1,260 1,097 --------------------------------------------------------------------------------------------------------------------------------- Income Before Cumulative Effect of Change in Accounting Principle 5,179 3,655 4,616 3,309 7,479 Cumulative Effect of Change in Accounting Principle, net of Income Taxes and Minority Interest 3,147 --------------------------------------------------------------------------------------------------------------------------------- Net Income $ 5,179 $ 508 $ 4,616 $ 3,309 $ 7,479 ================================================================================================================================= Basic Income from Continuing Operations per common share $ 1.23 $ .67 $ .92 $ .58 $ 2.06 Diluted Income from Continuing Operations per common share $ 1.14 $ .62 $ .85 $ .53 $ 1.69 Average Shares Outstanding: Common shares only 3,487 3,498 3,465 3,544 3,095 Common and potential common shares 3,765 3,770 3,763 3,851 3,945 ================================================================================================================================= Selected Balance Sheet Information Working Capital $ 13,314 $ 5,718 $ 7,633 $ 8,960 $ 18,736 Property, Plant and Equipment, net 43,088 56,666 57,362 56,227 51,410 Excess of Cost Over Net Assets Acquired, net 31,692 49,075 53,663 55,475 51,405 Total Assets 123,059 154,486 158,251 158,678 166,797 Long-Term Debt 57,529 75,148 79,642 84,378 86,282 Stockholders' Equity 48,044 42,249 42,241 39,108 39,982 --------------------------------------------------------------------------------------------------------------------------------- Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets".
17 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Hector Communications Corporation ("HCC") owns a 100% interest in five LEC subsidiaries and one cable television subsidiary. At December 31, 2003, these subsidiaries provided telephone service to 7,532 customers in 9 rural communities in Minnesota and Wisconsin. They also owned cable television systems serving 4,357 customers in Minnesota and Wisconsin. HCC's 100%-owned subsidiaries also have substantial ownership interests in other telecommunications ventures, including, Midwest Wireless Holdings LLC. HCC also owns a 100% interest in Alliance Telecommunications Corporation ("Alliance"). At December 31, 2003, Alliance, through its four LEC subsidiaries, provided telephone service to 22,350 customers in 19 rural communities in Minnesota, Wisconsin and North Dakota. Alliance's subsidiaries also provided cable television services to 4,752 subscribers in Minnesota. Alliance's subsidiaries also have substantial ownership interests in Midwest Wireless Holdings LLC and have other investments. Prior to July 7, 2003 Alliance Telecommunications Corporation ("Alliance") was 68% owned by HCC. ("Golden West") of Wall, South Dakota and Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota own the remaining interests in Alliance. Effective July 7, 2003 Alliance was reorganized under Section 355 of the Internal Revenue Code ("the split-up transactions'). In the split-up transactions, Golden West exchanged its minority ownership interest in Alliance for all of the outstanding stock of Sioux Valley Telephone Company, which included a pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. ACCI exchanged its minority ownership interest in Alliance for all of the outstanding stock of Hills Telephone Company, which included a pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. HCC became the 100% owner of all remaining Alliance assets and operations. (See "Split-up of Alliance Telecommunications Corporation" below.) The disclosures in this report related to prior periods have been restated to reflect the Company's continuing operations. Results of Operations ---------------------- 2003 Compared to 2002 --------------------- Consolidated revenues from continuing operations increased 6% to $32,322,000 in 2003 from $30,517,000 in 2002. The following table shows revenues by operating group for 2003 compared to 2002:
Alliance Hector Year Ended December 31 Year Ended December 31 2003 2002 2003 2002 --------------- ---------------- ---------------- ----------------- Local network $ 4,403,635 $ 4,263,544 $ 1,713,603 $ 1,611,184 Network access 11,001,000 10,195,887 5,074,254 5,107,970 Video services 1,929,285 2,098,331 1,650,488 1,600,459 Internet services 1,941,759 1,467,700 705,397 477,211 Other nonregulated services 3,092,427 3,025,315 810,580 669,189 --------------- ---------------- ---------------- ----------------- $ 22,368,106 $ 21,050,777 $ 9,954,322 $ 9,466,013 --------------- ---------------- ---------------- -----------------
Consolidated local service revenues increased 4% to $6,117,000 in 2003 from $5,875,000 in 2001. The increase was primarily due to increased revenues from CLASS service features (which include caller identification, call-waiting, call-forwarding and other related services) and custom calling. The Company increased the rates charged for these services during 2003. Access lines served were 29,882 at December 31, 2003, a decrease of 1% from 2002. The number of access lines the Company serves fell due to the reduced number of second lines being used for dial-up internet service and increased substitution of cellular phones for landline phones by customers. Network access revenues increased $771,000 or 5% to $16,075,000 in 2003. Universal service support funds received in 2003 increased $421,000 over 2002 due to investment in plant and equipment in the Sleepy Eye and Pine Island telephone exchanges. The Company's access revenues were reduced $437,000 in 2002 due to write-offs associated with the bankruptcy filings of World Com and Global Crossings. 18 Video service revenues decreased 3% to $3,580,000 in 2003. Revenues in 2003 were reduced by the sales of seven cable television systems serving 2,080 subscribers during the June 30 quarter. The lost revenues were offset in part by growth in Sleepy Eye and Pine Island, where broadband video services are available to customers. Revenues from internet services increased 36% to $2,647,000 due to increased availability of broadband DSL services to customers. The number of customers purchasing DSL services from the Company increased 74% in 2003, while the number of dial-up customers declined 1%. Revenues from other nonregulated services increased 6% to $3,903,000 due to higher retail sales, higher revenues from reselling long distance services and higher directory revenues which offset lower revenues from leases of fiber optic transport facilities, lower billing and collections revenues and lower fees from engineering services. Consolidated operating costs and expenses from continuing operations were $24,366,000 in 2003 compared to $23,875,000 in 2002. Costs and expenses by operating group were as follows:
Alliance Hector Year Ended December 31 Year Ended December 31 2003 2002 2003 2002 --------------- ---------------- ---------------- ----------------- Plant operations, excluding depreciation $ 3,084,408 $ 2,498,750 $ 1,432,303 $ 1,581,666 Depreciation and amortization 4,858,000 4,847,972 2,993,511 3,139,678 Customer operations 1,118,434 1,452,099 433,675 397,986 General and administrative 3,453,303 3,093,981 1,078,433 1,338,261 Other operating expenses: Video service expenses 1,599,510 1,760,900 1,427,103 1,423,033 Internet expenses 586,011 807,150 324,889 211,971 Other 1,499,547 873,358 476,655 448,614 --------------- ---------------- ---------------- ----------------- $ 16,199,213 $ 15,334,210 $ 8,166,569 $ 8,541,209 --------------- ---------------- ---------------- -----------------
Plant operations expenses, excluding depreciation, increased 11% to $4,517,000 in 2003 due to reduced capitalization of labor expenditures for new construction projects and severance charges for employee headcount reductions. Depreciation and amortization expenses decreased $136,000 due to sales of cable television properties during 2003. Customer operations expenses decreased 16% to $1,552,000 in 2003 due to employee headcount reductions. General and administrative expenses increased 2% to $4,532,000 in 2003 due to accounting and legal expenses incurred in the breakup of Alliance. Video service expenses declined 5% to $3,027,000 in 2003 due to the cable television systems sales, which offset increases in the fees the Company pays to video signal suppliers. Internet expenses decreased 11% to $911,000 in 2003 due to lower fees from "backbone" suppliers. Other operating expenses increased $654,000 or 49% due to increased cost of goods sold from retail sales and increased labor and materials charges for customer wiring installations and repairs and Next Level installations. Operating income from continuing operations increased 20% to $7,957,000 in 2003 from $6,641,000 in 2002. Consolidated interest expenses decreased $56,000 to $3,401,000 as lower interest rates on variable rate loans were offset by charges on new loan funds drawn down from the Rural Utilities Service and the Rural Telephone Bank. Income from the Company's investment in Midwest Wireless Holdings LLC decreased to $2,148,000 in 2003 from $2,261,000 in 2002. Midwest Wireless' 2003 income declined due to decreases in roamer service revenues and increased costs for converting customers from TDMA to CDMA technology. Income from investments in other unconsolidated affiliates was $96,000 in 2003 compared to a loss of $56,000 in 2002. Interest and dividend income increased to $392,000 in 2003 from $334,000 in 2002 due to increases in the Company's cash balances available for investment. The Company recorded gains on sales of cable television systems totaling $1,081,000 in the 2003 period. Alliance recorded an impairment loss on its marketable securities portfolio of $134,000 in 2002. Income from continuing operations before income taxes and minority interest increased to $8,273,000 in 2003 from $5,589,000 in 2002. The Company's effective income tax rate was 40% in 2003 compared to 44% in 2002. The Company's tax rate declined due to the reduced effects of state income taxes caused by 19 changes in apportionment. Minority interest on earnings of Alliance's continuing operations was $660,000 for the period of 2003 prior to the split-up transaction compared to $781,000 for all of 2002. Income from continuing operations increased to $4,297,000 in 2003 from $2,324,000 in 2002. Income from discontinued operations before minority interest and gain on the split-up transaction in 2003 was $989,000. Minority interests in those earnings were $316,000. Income from discontinued operations in 2002 was $1,957,000. Minority interests in those earnings were $626,000. The Company recorded a gain, net of income taxes, of $210,000 on the Alliance breakup transactions. In 2002, the Company took a charge against earnings related to the cumulative effect of impairment of the value of its goodwill and intangible assets of $3,147,000, net of income taxes and minority interest. The Company had net income of $5,179,000 in 2003 compared to $508,000 in 2002. 2002 Compared to 2001 --------------------- Consolidated revenues from continuing operations decreased 2% to $30,517,000 in 2002 from $31,073,000 in 2001. The following table shows revenues by operating group for 2002 compared to 2001:
Alliance Hector Year Ended December 31 Year Ended December 31 2002 2001 2002 2001 --------------- ---------------- ---------------- ----------------- Local network $ 4,263,544 $ 4,015,282 $ 1,611,184 $ 1,562,398 Network access 10,195,887 10,275,933 5,107,970 5,652,977 Video services 2,098,331 2,064,549 1,600,459 1,465,078 Internet services 1,467,700 1,282,484 477,211 308,924 Other nonregulated services 3,025,315 3,627,880 669,189 817,732 --------------- ---------------- ---------------- ----------------- $ 21,050,777 $ 21,266,128 $ 9,466,013 $ 9,807,109 --------------- ---------------- ---------------- -----------------
Local network revenues increased 5% to $5,875,000 in 2002. Revenue growth in Alliance was due to the full year effect of a 2001 local service rate increase at Sleepy Eye Telephone Company. Hector's local network revenues increased due to increases in the number of access lines served. Network access revenues declined $625,000 or 4% to $15,304,000 in 2002. The Company's access revenues were reduced $437,000 in 2002 due to write-offs associated with the bankruptcy filings of World Com and Global Crossings. Interstate access revenues were negatively affected by FCC mandated reductions in NECA's tariff rates. Universal service support increased due to Alliance's increased investment in plant and equipment in Sleepy Eye. Video service revenues increased 5% to $3,699,000 due to rate increases and introduction of broadband video services in Sleepy Eye. Revenues from internet services increased 22% to $1,945,000 due to increased customer acceptance of the technology and increased availability of broadband DSL services to customers. Revenues from other nonregulated services decreased $751,000 to $3,695,000 due to lower revenues from leases of fiber optic transport facilities, lower billing and collections revenues and lower retail sales. Consolidated operating costs and expenses were $23,875,000 in 2002 compared to $24,404,000 in 2001. If the provisions of SFAS 142 had been in effect at January 1, 2001, 2001 operating costs would have been $22,574,000. Costs and expenses by operating group were as follows:
Alliance Hector Year Ended December 31 Year Ended December 31 2002 2001 2002 2001 --------------- ---------------- ---------------- ----------------- Plant operations, excluding depreciation $ 2,498,750 $ 2,492,728 $ 1,581,666 $ 1,381,781 Depreciation and amortization 4,847,972 6,342,827 3,139,678 3,178,259 Customer operations 1,452,099 1,442,561 397,986 384,286 General and administrative 3,093,981 2,621,067 1,338,261 1,268,523 Other operating expenses: Video service expenses 1,760,900 1,511,890 1,423,033 1,329,244 Internet expenses 807,150 826,931 211,971 176,692 Other 873,358 998,540 448,614 448,682 --------------- ---------------- ---------------- ----------------- $ 15,334,210 $ 16,236,544 $ 8,541,209 $ 8,167,467 --------------- ---------------- ---------------- -----------------
20 Plant operations expenses, excluding depreciation, increased 5% to $4,080,000. Depreciation expense increased $297,000 due to depreciation on new plant additions. Amortization expense decreased $1,830,000 due to the adoption of SFAS #142. Customer operations expenses increased 1% to $1,850,000 in 2002. General and administrative expenses increased 14% to $4,432,000 in 2002 due to accounting and legal expenses incurred in the breakup of Alliance. Video service expenses increased 12% to $3,184,000 in 2002 due to increases in the fees the Company pays to video signal suppliers. Internet expenses increased $15,000. Other operating expenses decreased $125,000 or 9% due to decreased costs associated with lower retail sales. Operating income from continuing operations decreased $28,000 to $6,641,000 in 2002. Interest expenses decreased $371,000 to $3,457,000 in 2002. The decrease was due to lower interest rates on variable rate debt from CoBank and lower debt levels due to principal payments. Income from the Company's investment in Midwest Wireless Holdings LLC increased to $2,261,000 in 2002 from $1,152,000 in 2001. Midwest Wireless' 2001 results included amortization of intangible assets totaling $721,000, which ceased with the adoption of SFAS 142. The Company had a loss from investments in other unconsolidated affiliates of $56,000 in 2002 compared to income of $336,000 in 2001 due to lower profits from fiber optic transport company investments and losses from the Company's investment in Desktop Media. Alliance recorded an impairment loss on its marketable securities portfolio of $134,000 in 2002. Alliance had gains on sales of marketable securities of Illuminet, Inc. totaling $3,659,000 in 2001. Interest and dividend income decreased to $334,000 in 2002 from $432,000 in 2001 due to lower interest rates on invested funds and lower dividend yields from marketable security investments. Income from continuing operations before income taxes and minority interest decreased to $5,589,000 in 2002 from $8,422,000 in 2001. The Company's effective income tax rate was 44% compared to 49% in 2001. The Company's tax rate declined due to the adoption of SFAS #142, which eliminated amortization of nondeductible goodwill. Income from continuing operations before the minority interest in Alliance's earnings decreased to $3,106,000 in 2002 from $4,260,000 in 2001. Minority interest on earnings of Alliance was $781,000 compared to $1,078,000 in 2001. Income from continuing operations was $2,324,000 in 2002 compared to $3,181,000 in 2001. Income from discontinued operations before minority interest was $1,957,000 in 2002 compared to $2,110,000 in 2001. Minority interests in those earnings were $626,000 and $675,000, respectively. In 2002, the Company took a charge against earnings related to the cumulative effect of impairment of the value of its goodwill and intangible assets, before income tax benefits and minority interest, of $4,663,000. After income tax benefits of $121,000 and minority interest of $1,395,000, the net charge against earnings was $3,147,000 (see Note 4 to the consolidated financial statements). Net income for 2002 was $508,000 compared to $4,616,000 in 2001. Liquidity and Capital Resources ------------------------------- Operations Cash flows from consolidated operating activities (including the activities of discontinued operations up to the Alliance split-up date) were $12,953,000, $13,116,000 and $14,103,000 in 2003, 2002 and 2001, respectively. At December 31, 2003, the Company's cash and cash equivalents totaled $16,581,000 compared to $12,020,000 at December 31, 2002. Cash and cash equivalents held by discontinued operations were $2,428,000 of this total at December 31, 2002. Working capital at December 31, 2003 was $13,314,000 compared to $5,718,000 at December 31, 2002. The current ratio was 2.1 to 1 at December 31, 2003 compared to 1.4 to 1 at December 31, 2002. The Company makes periodic improvements to its facilities to provide up-to-date services to its telephone and cable television customers. Hector's plant additions in 2003, 2002 and 2001 were $1,398,000, $2,609,000 and $3,985,000 respectively. Alliance's plant additions for continuing operations in 2003, 2002 and 2001 were $2,258,000, $5,121,000 and $4,635,000 respectively. Plant additions for discontinued operations up to the split-up date were $257,000, $1,536,000 and $1,999,000 in 2003, 2002 and 2001, respectively. Plant additions for 2004 for Hector and Alliance are expected to total $4,387,000. 21 These plant additions will upgrade the Company's telephone equipment to allow local number portability and other advanced telecommunications services, expand telecommunications services into new construction developments and increase usage of Next Level broadband equipment and high capacity fiber optics in the telephone network. Long-Term Obligations and Commitments -------------------------------------- The Company's LEC subsidiaries borrow from the Rural Utilities Service ("RUS") and the Rural Telephone Bank ("RTB") to help finance asset additions. Proceeds from long-term borrowings from RUS and RTB were $5,998,000, $2,954,000 and $2,201,000 in 2003, 2002 and 2001, respectively. The average interest rate on outstanding RUS and RTB loans is 5.0%. At December 31, 2003 unadvanced loan commitments from the RUS and RTB to Hector's and Alliance's LEC subsidiaries totaled $13,299,000. Substantially all of the assets of the Company's LEC subsidiaries are pledged or are subject to mortgages to secure obligations to the RUS and RTB. The Company's loan agreements place significant restrictions on cash distributions from the subsidiaries to the parent company. Alliance's loan covenants with CoBank also restrict dividend payments at the Alliance level. At December 31, 2003, $11,863,000 of subsidiaries' retained earnings was available for dividend payments to HCC. At December 31, 2003, $32,614,000 of HCC's retained earnings were not available to pay dividends to shareholders due to restrictions in the debt agreements. It is the Company's plan, in so far as possible, to maintain its cash balances at the subsidiary level to support their operations. The Company carries a significant amount of debt due to borrowing to finance Alliance's acquisition of Ollig Utilities Company. Prior to the split-up transaction, Alliance and its subsidiaries carried this debt. In July 2003 the Company repaid the acquisition loan with proceeds from a new term loan provided to Hector by CoBank. The loan is secured by a pledge of the stock of Hector's subsidiary companies. Interest rates on long-term portions of the loan are fixed through 2007, while the non-fixed portion floats at short-term market rates. The average rate on the total loan was approximately 4.4% at December 31, 2003. Principal payments are made quarterly and will continue until April 2013. The outstanding balance on this loan at December 31, 2003 was $26,125,000. CoBank is a cooperative, owned and controlled by its customers. Each customer borrowing from the bank on a patronage basis shares in the bank's net income through payment of patronage refunds. As a condition of maintaining the loan, Hector owns stock in the bank. Its investment in CoBank stock was $2,555,000 at December 31, 2003. As part of financing its ownership interest in Alliance, Hector had a 15-year term loan from Rural Telephone Finance Cooperative ("RTFC"). At December 31, 2002 the outstanding balance on this loan was $3,157,000. The loan was repaid in July 2003 as part of the CoBank refinancing. In addition to its debt agreements, Hector and its subsidiaries have entered into contracts with suppliers to provide capital equipment, switching services and fiber optic transport facilities. The Company's cash payments due for these obligations are as follows (interest payments are estimated using December 31, 2003 interest rates):
Long-Term Interest Purchase Operating Total Debt Payments Obligations Leases --------------- --------------- ---------------- ---------------- ----------------- 2004 $ 10,453,500 $ 6,537,800 $ 2,920,500 $ 639,900 $ 355,300 2005 9,216,800 6,340,900 2,639,400 236,500 2006 8,975,500 6,451,800 2,369,400 154,300 2007 8,818,300 6,650,000 2,094,200 74,100 2008 8,201,000 6,650,000 1,476,800 74,200 After 2008(1) 35,499,278 31,436,678 4,031,400 31,200 --------------- --------------- ---------------- ---------------- ----------------- $ 81,164,378 $ 64,067,178 $ 15,531,700 $ 639,900 $ 925,600 =============== --------------- ---------------- ---------------- -----------------
(1) The Company has an obligation to pay Broadband Visions LLC ("BBV") $6,000 per month for fiber optic transport facilities until such time that the Company is not a member of BBV. This obligation is reflected in the table for each year from 2004 through 2008. No amount is included after 2008. 22 Investments ----------- Investment income has been derived almost exclusively from interest earned on the Company's cash and cash equivalents. Interest income has fluctuated in relation to changes in interest rates and availability of cash for investment. In 2001 Alliance received $3,675,000 from sales of marketable securities, principally Illuminet, Inc. common stock. The Company does not expect proceeds from marketable securities sales in future years be significant. The Company regularly invests cash in new telecommunications technologies and ventures and in support of its existing affiliated interests. In 2001 the Company invested $500,000 in Desktop Media, Inc., a start-up company providing voice, data and internet telecommunications services in southeastern Minnesota. The Company also invested $360,000 to support its investment in a fiber optic transport company in northwestern Minnesota. The Company expects to make additional investments of this type as opportunities arise. The Company owned 10.4% of Wireless North, which provided personal communications services ("PCS") to parts of Minnesota, Wisconsin, Iowa, North Dakota and South Dakota. Wireless North was unsuccessful and has been liquidated. Its licenses and systems were sold to other operators, or were shut down. In 2001, the Company made payments to Wireless North's primary lender of $1,129,000 to satisfy loan guarantees it gave with respect to Wireless North's debt. Cash investments in Wireless North by the Company totaled $3,202,000. The Company has written off its entire investment in Wireless North, has no obligation to provide additional funding and does not expect to realize any additional value from this investment. The Company's other investments consist primarily of loan related bank stocks, long-term investments in non-marketable corporations, and notes receivable. In 2002, the Company made investments in mutual funds and rural development note receivables that were funded by no-interest loans from the Rural Utilities Service. Credit Risk ----------- Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and temporary cash investments. The Company places its cash investments with high credit quality financial institutions. The Company maintains its cash in bank deposit accounts. The account balances at times exceed the federally insured limits. The Company has not experienced losses in these accounts and does not believe they are exposed to any significant credit risk. A significant portion of the Company's revenues are received from long distance carriers in the telephone industry. Consequently, the Company is directly affected by the financial well-being of that industry. The credit risk associated with these accounts is minimized due to the large number of long distance carriers. Common Stock ------------ The Company's Board of Directors has authorized the purchase and retirement, from time to time, of shares of the Company's stock on the open market, or in private transactions consistent with overall market and financial conditions. In 2003 the Company purchased and retired 1,106 shares at a cost of $17,000. In 2002 the Company purchased and retired 70,239 shares at a cost of $737,000. In 2001 the Company purchased and retired 109,704 shares at a cost of $1,268,000. At December 31, 2003 215,000 shares could be repurchased under outstanding Board authorizations. Proceeds to the Company from exercises of employee stock options and employee stock purchase plan shares totaled $431,000, $320,000 and $550,000 in 2003, 2002 and 2001, respectively. Sales of Cable Television Systems --------------------------------- Alliance completed sales of two groups of cable television systems during the second quarter of 2003. Alliance sold four systems in rural North Dakota serving 930 subscribers to MLGC, LLC for $200,000 of cash and a note receivable of $650,000. Alliance sold systems serving 1,150 subscribers in three communities surrounding the Fargo, ND - Moorhead, MN area to Cable One, Inc. for $1,545,000 of cash (including $80,000 of escrowed funds). Effect of the asset sales was as follows: 23 Sales Price $ 2,395,032 Less: Property, plant and equipment (net) (343,636) Less: Intangible assets (goodwill) (970,673) ------------- Gain on sale of cable assets $ 1,080,723 ============= By utilizing cash flow from operations, current cash and investment balances, and other available financing sources, the Company feels it has adequate resources to meet its anticipated operating, debt service and capital expenditure requirements. Split-Up of Alliance Telecommunications Corporation --------------------------------------------------- In July 2001, Golden West and ACCI, respectively the 20% and 12% minority shareholders of Alliance, advised the Company that they were interested in exchanging their minority investment for a share of the assets and liabilities of Alliance. Thereafter the parties engaged in negotiations that continued through December 2002. The negotiation process included evaluations and appraisals of Alliance's business components, negotiations with Alliance's lenders (CoBank, Rural Utilities Service and Rural Telephone Bank) regarding waivers, lien releases, interest penalties where applicable and future financing terms. The process also included seeking necessary regulatory approvals from local, state and national regulators. The Company completed the Alliance split-up transactions on July 7, 2003. As agreed among the parties, in the split-up, Golden West exchanged its 20% ownership interest in Alliance for all of the outstanding stock of Sioux Valley Telephone Company, which included a pro rata share of Alliance's ownership in Midwest Wireless Holdings, LLC and certain other Alliance assets. ACCI exchanged its 12% ownership interest in Alliance for all of the outstanding stock of Hills Telephone Company, which included a pro rata share of Alliance's ownership in Midwest Wireless Holdings, LLC and certain other Alliance assets. Immediately prior to the breakup Sioux Valley and Hills paid a dividend to Alliance of approximately $12,849,000. The dividend proceeds were applied to repay a portion of Alliance's acquisition loan from CoBank. Concurrent with the split-up, the balance of Alliance's debt to CoBank and the balance of the Company's debt to Rural Telephone Finance Cooperative were retired using proceeds from a new $26,813,000 loan from CoBank to Hector Communications Corporation. A number of other stock and asset transfers also occurred among Alliance and its subsidiaries prior to the split-up in order to satisfy various regulatory and lender requirements. The Company believes the split-up transactions are tax-free under Section 355 of the Internal Revenue Code. The Company also believes that related internal stock and asset transfers that occurred prior to the split-up are tax-free under Section 355, related Code provisions and the consolidated return regulations, although no private letter ruling was sought from the IRS in connection with the split-up. Prior to conducting the split-up transactions, the parties entered agreements with regard to cooperation, exchange of information, interim use of common services, employee benefits, tax allocations and indemnification generally in proportion to ownership percentages with respect to unexpected adverse tax consequences, and other matters arising after the split-up transactions which relate to commitments, events or circumstances in effect as of the date of the split-up transactions. Acquisitions ------------ The Company is continually evaluating possible acquisitions that advance its plan to be a provider of top quality telecommunications services to rural customers. In the past, the Company has been a member of investor groups that sought unsuccessfully to acquire rural telephone properties offered for sale by major telephone companies. The Company cannot predict if it will be successful in acquiring additional properties and does not currently have financing plans in place to pay for possible acquisitions. Effects of Inflation -------------------- The Company's local exchange telephone companies are subject to the jurisdiction of Minnesota, North Dakota and Wisconsin regulatory authorities with respect to a variety of matters, including rates for intrastate access services, the conditions and quality of service, issuance of debt, depreciation rates and accounting methods. Rates for local telephone service are not 24 established directly by regulatory authorities, but their authority over other matters limits the Company's ability to implement rate increases. In addition, the regulatory process inherently restricts the Company's ability to immediately pass cost increases along to customers unless the cost increases are anticipated and the rate increases implemented prospectively. Critical Accounting Policies ---------------------------- The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reporting of the Company's operating resulting and financial position. The estimates and assumptions used in the Company's financial statements are based upon management's evaluation of the relevant facts and circumstances as of the time of the financial statements. These estimates are often difficult, subjective and complex. Actual results could differ from the estimates. HCC also gives accounting recognition to the actions of federal and state regulatory authorities where appropriate as prescribed by SFAS No. 71. Revenue recognition: Revenues are recognized when earned, regardless of the period in which they are billed. Network access revenues are furnished in conjunction with interexchange carriers and are determined by cost separation studies and nationwide average schedules. Revenues include estimates pending finalization of cost studies. Network access revenues are based upon interstate tariffs filed with the Federal Communications Commission by the National Exchange Carriers Association and state tariffs filed with state regulatory agencies. Management believes recorded revenues are reasonable based on estimates of final cost separation studies, which are typically settled within two years. Allowance for Doubtful Accounts: The allowance for doubtful accounts is an estimate based on specifically identified problem accounts and historical collection experience. Specific accounts are evaluated where the Company has information that the customer may not be able to meet its financial obligations, where payment is delinquent or where charges are in dispute. Reserves are reevaluated and adjusted as information affecting the accounts is received. If circumstances change, recoverability of amounts due the Company could be materially affected. Property, plant and equipment: The Company regularly reviews the carrying value of its fixed assets for impairment. Carrying values are estimated based on expected future cash flows and/or established market valuations of other similar assets. Depreciation is calculated using the straight-line method based on the estimated useful lives of the various asset classes. Reserves established for asset retirement obligations have not been significant. Goodwill and intangible assets: Effective January 1, 2002 the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". Under the provisions of this accounting standard, goodwill and intangible assets with indefinite useful lives are no longer amortized but are instead tested for impairment on at least an annual basis. The goodwill impairment test requires the Company to determine the fair value of its reporting units. The valuation is estimated based on access line and customer valuations and cash flow multiple valuations the Company considers appropriate in the current marketplace. If circumstances or assumptions supporting these estimates change, the carrying value of the Company's goodwill could be materially affected. Income taxes: The Company estimates its income tax expense for each jurisdiction in which it operates. The process includes apportioning the Company's income among the jurisdictions, estimating current tax liabilities and establishing deferred tax assets and liabilities. Deferred taxes are calculated where the carrying amounts of assets and liabilities are different for financial and tax reporting purposes. Valuation allowances are recorded in the tax accounts for amounts management believes are not recoverable in future periods. New Accounting Standards ------------------------ Effective January 1, 2003 the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations". The statement establishes accounting standards for recognition and measurement of a liability for an asset retirement obligation and an associated asset retirement cost. The statement applies to tangible long-lived assets, including individual assets, functional groups of related assets and significant parts of assets. It covers a company's legal obligations resulting from the acquisition, construction, development or normal operation of 25 a capital asset. The FCC has notified the Company's ILEC subsidiaries that SFAS No. 143 will not be adopted for regulatory purposes. Current regulatory accounting requires ILECs to accrue for asset retirement obligations through prescribed depreciation rates. The amount of asset retirement obligations the Company is required to record under SFAS No. 143 is not significant. Adoption of the provisions of SFAS No. 143 did not have a material impact on the Company's financial position or operating results. In November 2002 the Financial Accounting Standards Board ("FASB") issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This interpretation elaborates on the disclosures required in financial statements concerning obligations under certain guarantees. It also clarifies the requirements related to the recognition of liabilities by a guarantor at the inception of certain guarantees. The disclosure requirements of this interpretation were effective on December 31, 2002, but did not require any additional disclosures on the part of the Company. The recognition provisions of the interpretation effective for 2003 are applicable only to guarantees issued or modified after December 31, 2002. Adoption of these provisions did not have a material impact on the Company's financial position or results of operations. In June 2002 the FASB issued SFAS No.146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue No. 94-3, a liability for an exit cost was recognized at the date of the entity committed to an exit plan. The provisions of this statement were effective for exit or disposal activities initiated after December 31, 2002. Adoption of SFAS No. 146 did not have a material impact on the Company's financial position or results of operations. In April 2003 the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies accounting and reporting for derivative instruments. SFAS No. 149 is effective for contracts made or modified after June 30, 2003. Adoption of SFAS No. 149 did not have a material effect on the Company's financial position or results of operations. In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equities", which became effective for the Company with this report. Adoption of this statement did not have a material impact on the Company's consolidated results of operations and financial position. In December 2003, the FASB issued a revision of SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits". The statement revises the disclosures required for pension and other post-retirement benefit plans. The new disclosure requirements are reflected in the Company's Notes to Consolidated Financial Statements in this report as appropriate. In December 2003, the FASB issued a revised Financial Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities". FIN No. 46 requires the assets, liabilities and results of operations of variable interest entities to be included in the Company's financial statements if the entities have certain financial characteristics. FIN No. 46 is effective for investments in special-purpose entities for periods ending after December 15, 2003, and for other types of entities for periods ending after March 15, 2004. Adoption of FIN No. 46 did not result in consolidation or change the Company's disclosures for any of the entities in which it maintains investments. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company does not use derivative financial instruments in its operations or investment portfolio. Its operations are not subject to risks associated with changes in the value of foreign currencies. Portions of the Company's long-term debt have variable interest rates based on the lenders' cost of money. The Company has investments in money market funds and mutual funds that earn interest at prevailing market rates. In the opinion of management, the Company does not have a material exposure to loss caused by market risk. 26 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA (a) FINANCIAL STATEMENTS REPORT OF MANAGEMENT The management of Hector Communications Corporation and its subsidiary companies is responsible for the integrity and objectivity of the financial statements and other financial information contained in the annual report. The financial statements and related information were prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management's informed judgments and estimates. In fulfilling its responsibilities for the integrity of financial information, management maintains accounting systems and related controls. These controls provide reasonable assurance, at appropriate costs, that assets are safeguarded against losses and that financial records are reliable for use in preparing financial statements. Management recognizes its responsibility for conducting the Company's affairs according to the highest standards of personal and corporate conduct. The Audit Committee of the Board of Directors, composed solely of outside directors, meets with the independent auditors and management periodically to review accounting, auditing, financial reporting and internal control matters. The independent auditors have free access to this committee, without management present to discuss the results of their audit work and their opinion on the adequacy of internal financial controls and the quality of financial reporting. /s/ Curtis A. Sampson /s/ Charles A. Braun ---------------------------- ----------------------------------- Curtis A. Sampson Charles A. Braun Chairman and Chief Executive Officer Chief Financial Officer INDEPENDENT AUDITORS' REPORT To the Shareholders and Board of Directors of Hector Communications Corporation We have audited the accompanying consolidated balance sheets of Hector Communications Corporation and subsidiaries as of December 31, 2003 and 2002 and the related consolidated statements of income, comprehensive income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hector Communications Corporation and subsidiaries as of December 31, 2003 and 2002 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. As described in Note 4 to the consolidated financial statements, effective January 1, 2002 the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets". /s/ Olsen Thielen & Co., Ltd. Olsen Thielen & Co., Ltd. February 13, 2004 St. Paul, Minnesota 27
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS December 31 ----------------------------------- 2003 2002 -------------- -------------- CURRENT ASSETS: Cash and cash equivalents $ 16,581,315 $ 12,020,186 Construction fund (Note 9) 3,240,073 662,232 Accounts receivable (net of allowance for doubtful accounts of $538,000 and $716,000, respectively) 4,140,052 4,819,174 Materials, supplies and inventories, at average cost 944,099 1,175,587 Other current assets 285,071 231,685 -------------- -------------- TOTAL CURRENT ASSETS 25,190,610 18,908,864 PROPERTY, PLANT AND EQUIPMENT, net (Notes 1 and 3) 43,088,106 56,665,798 INVESTMENTS AND OTHER ASSETS: Excess of cost over net assets acquired (Notes 1 and 4) 31,691,927 49,074,993 Investment in Midwest Wireless Holdings LLC (Note 5) 13,349,155 16,232,707 Investments in other unconsolidated affiliates (Note 6) 2,796,035 4,373,597 Other investments (Notes 1 and 7) 6,533,858 8,818,502 Other assets (Notes 1 and 4) 409,664 411,499 -------------- -------------- TOTAL OTHER ASSETS 54,780,639 78,911,298 -------------- -------------- TOTAL ASSETS $ 123,059,355 $ 154,485,960 ============== ============== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Notes payable and current portion of long-term debt (Note 9) $ 6,537,800 $ 7,364,600 Accounts payable (Note 12) 1,557,969 2,523,878 Accrued expenses 2,238,587 2,422,986 Income taxes payable 1,541,830 879,417 -------------- -------------- TOTAL CURRENT LIABILITES 11,876,186 13,190,881 LONG-TERM DEBT, less current portion (Note 9) 57,529,378 75,147,560 DEFERRED INVESTMENT TAX CREDITS (Note 8) 8,999 27,554 DEFERRED INCOME TAXES (Note 8) 4,902,870 5,866,754 DEFERRED COMPENSATION (Note 11) 698,254 976,179 COMMITMENTS AND CONTINGENCIES (Note 9) MINORITY INTEREST IN ALLIANCE TELECOMMUNICATIONS, CORP. 17,027,697 STOCKHOLDERS' EQUITY: (Notes 1, 9 and 10) Preferred stock, par value $1.00 per share; 3,000,000 shares authorized: Convertible Series A, 220,100 shares issued and outstanding 220,100 220,100 Common stock, par value $.01 per share; 10,000,000 shares authorized; 3,515,482 and 3,455,067 shares issued and outstanding 35,155 34,551 Additional paid-in capital 13,828,414 13,262,969 Retained earnings 33,908,774 28,742,832 -------------- -------------- 47,992,443 42,260,452 Accumulated other comprehensive income (loss) (Note 7) 51,225 (11,117) -------------- -------------- TOTAL STOCKHOLDERS' EQUITY 48,043,668 42,249,335 -------------- -------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 123,059,355 $ 154,485,960 ============== ============== See notes to consolidated financial statements.
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HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Year Ended December 31 --------------------------------------------- 2003 2002 2001 ----------- ----------- ----------- REVENUES FROM CONTINUING OPERATIONS: Local network $ 6,117,238 $ 5,874,728 $ 5,577,680 Network access 16,075,254 15,303,857 15,928,910 Video services 3,579,773 3,698,790 3,529,627 Internet services 2,647,156 1,944,911 1,591,408 Other nonregulated services 3,903,007 3,694,504 4,445,612 ----------- ----------- ----------- TOTAL REVENUES 32,322,428 30,516,790 31,073,237 COSTS AND EXPENSES: Plant operations, excluding depreciation 4,516,711 4,080,416 3,874,509 Depreciation and amortization 7,851,511 7,987,650 9,521,086 Customer operations 1,552,109 1,850,085 1,826,847 General and administrative 4,531,736 4,432,242 3,889,590 Other operating expenses: Video service expenses 3,026,613 3,183,933 2,841,134 Internet expenses 910,900 1,019,121 1,003,623 Other 1,976,202 1,321,972 1,447,222 ----------- ----------- ----------- TOTAL COSTS AND EXPENSES 24,365,782 23,875,419 24,404,011 ----------- ----------- ----------- OPERATING INCOME FROM CONTINUING OPERATIONS 7,956,646 6,641,371 6,669,226 OTHER INCOME (EXPENSES): Interest expense (3,401,479) (3,457,093) (3,827,678) Income (loss) from investments in unconsolidated affilates: Midwest Wireless Holdings, LLC (Note 5) 2,148,444 2,261,420 1,152,574 Other unconsolidated affiliates (Note 6) 96,299 (56,311) 336,039 Interest and dividend income 391,897 333,711 432,356 Gain on sale of cable television systems (Note 14) 1,080,723 Gain (loss) on sale of marketable securities (Note 7) (134,498) 3,659,055 ----------- ----------- ----------- OTHER INCOME (EXPENSES), net 315,884 (1,052,771) 1,752,346 ----------- ----------- ----------- INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES AND MINORITY INTEREST 8,272,530 5,588,600 8,421,572 Income tax expense (Note 8) 3,316,000 2,483,000 4,162,000 ----------- ----------- ----------- INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTEREST 4,956,530 3,105,600 4,259,572 Minority interest in continuing operations of Alliance Telecommunications Corp. (659,624) (781,403) (1,078,391) ----------- ----------- ----------- INCOME FROM CONTINUING OPERATIONS 4,296,906 2,324,197 3,181,181 DISCONTINUED OPERATIONS (Note 2): Income from operations of asset group distributed in split-up of Alliance Telecommunications Corporation, net of income taxes 988,748 1,956,900 2,110,255 Minority interest in discontinued operations of Alliance Telecommunications Corp. (316,399) (626,208) (675,282) Gain on split-up of Alliance Telecommunications Corp., net of income taxes 209,505 ----------- ----------- ----------- INCOME FROM DISCONTINUED OPERATIONS 881,854 1,330,692 1,434,973 ----------- ----------- ----------- INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 5,178,760 3,654,889 4,616,154 Cumulative effect of change in accounting principle, net of income taxes and minority interest (3,146,569) ----------- ----------- ----------- NET INCOME $ 5,178,760 $ 508,320 $ 4,616,154 =========== =========== =========== BASIC NET INCOME PER COMMON SHARE (Note 1): Before cumulative effect of change in accounting principle: Continuing operations $ 1.23 $ .67 $ .92 Discontinued operations .25 .38 .41 Cumulative effect of accounting change (.90) ----------- ----------- ----------- $ 1.48 $ .15 $ 1.33 =========== =========== =========== DILUTED NET INCOME PER COMMON SHARE (Note 1): Before cumulative effect of change in accounting principle: Continuing operations $ 1.14 $ .62 $ .85 Discontinued operations .23 .35 .38 Cumulative effect of accounting change (.84) ----------- ----------- ----------- $ 1.37 $ .13 $ 1.23 =========== =========== =========== AVERAGE SHARES OUTSTANDING (Notes 1 and 10): Common shares only 3,487,000 3,498,000 3,465,000 Common and potential common shares 3,765,000 3,770,000 3,763,000 See notes to consolidated financial statements.
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HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Year Ended December 31 ----------------------------------------------------- 2003 2002 2001 ------------- ------------- ------------- Net income $ 5,178,760 $ 508,320 $ 4,616,154 Other comprehensive income (loss): Unrealized holding gains (losses) on marketable securities 97,612 (304,758) 1,199,251 Reclassification adjustment for losses (gains) included in net income 134,498 (3,659,055) ------------- ------------- ------------- Other comprehensive income (loss) before income taxes 97,612 (170,260) (2,459,804) ------------- ------------- ------------- Income tax expense (benefit) related to unrealized holding gains and losses on marketable securities 39,053 (125,492) 492,948 Income tax expense (benefit) related to reclassification adjustment for gains and losses included in net income 0 53,799 (1,504,043) ------------- ------------- ------------- Income tax expense (benefit) related to items of other comprehensive loss 39,053 (71,693) (1,011,095) Minority interest in other comprehensive loss of Alliance Telecommunications Corporation (3,783) (16,138) (458,786) ------------- ------------- ------------- Other comprehensive income (Ioss) 62,342 (82,429) (989,923) ------------- ------------- ------------- Comprehensive income $ 5,241,102 $ 425,891 $ 3,626,231 ============= ============= ============= See notes to consolidated financial statements
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HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Accumulated Preferred Stock Common Stock Additional Other -------------------- -------------------- Paid-in Retained Comprehensive Shares Amount Shares Amount Capital Earnings Income (Loss) Total --------- --------- --------- -------- ------------ ------------ ----------- ------------ BALANCE AT DECEMBER 31, 2000 221,300 $ 221,300 3,504,363 $ 35,044 $ 12,844,776 $ 24,945,512 $ 1,061,235 $ 39,107,867 Net income 4,616,154 4,616,154 Issuance of common stock under Employee Stock Purchase Plan 11,626 116 136,998 137,114 Issuance of common stock under Employee Stock Option Plan 52,375 524 412,351 412,875 Issuance of common stock in exchange for preferred stock (1,200) (1,200) 1,200 12 1,188 0 Issuance of common stock to ESOP 16,709 167 225,026 225,193 Purchase and retirement of common stock (109,704) (1,097) (407,369) (859,521) (1,267,987) Change in unrealized gains on marketable securities, net of deferred taxes (989,923) (989,923) --------- --------- --------- -------- ------------ ------------ ----------- ------------ BALANCE AT DECEMBER 31, 2001 220,100 220,100 3,476,569 34,766 13,212,970 28,702,145 71,312 42,241,293 Net income 508,320 508,320 Issuance of common stock under Employee Stock Purchase Plan 11,578 116 96,827 96,943 Issuance of common stock under Employee Stock Option Plan 37,159 371 222,292 222,663 Purchase and retirement of common stock (70,239) (702) (269,120) (467,633) (737,455) Change in unrealized gains on marketable securities, net of deferred taxes (82,429) (82,429) --------- --------- --------- -------- ------------ ------------ ----------- ------------ BALANCE AT DECEMBER 31, 2002 220,100 220,100 3,455,067 34,551 13,262,969 28,742,832 (11,117) 42,249,335 Net income 5,178,760 5,178,760 Issuance of common stock under Employee Stock Purchase Plan 15,685 157 131,166 131,323 Issuance of common stock under Employee Stock Option Plan 34,836 348 299,572 299,920 Issuance of common stock to Employee Stock Ownership Plan 11,000 110 139,040 139,150 Purchase and retirement of common stock (1,106) (11) (4,333) (12,818) (17,162) Change in unrealized gains on marketable securities, net of deferred taxes 62,342 62,342 --------- --------- --------- -------- ------------ ------------ ----------- ------------ BALANCE AT DECEMBER 31, 2003 220,100 $ 220,100 3,515,482 $ 35,155 $ 13,828,414 $ 33,908,774 $ 51,225 $ 48,043,668 ========= ========= ========= ======== ============ ============ =========== ============ See notes to consolidated financial statements.
31
HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31 ----------------------------------------------- 2003 2002 2001 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net Income $ 5,178,760 $ 508,320 $ 4,616,154 Adjustments to reconcile net income to net cash provided by operating activities: Noncash cumulative effect of change in accounting principle 4,663,039 Depreciation and amortization 8,798,414 9,963,888 11,318,010 Minority stockholders' interest in earnings of Alliance Telecommunications Corporation 976,023 12,632 1,753,673 Gain on split-up of Alliance Telecommunications Corporation (348,505) Gains on sales of cable television systems (1,080,723) Gains on sales of marketable securities (3,659,055) Noncash marketable securities impairment charge 134,498 Income from Midwest Wireless Holdings LLC (2,533,703) (2,928,251) (1,474,865) Income from other unconsolidated affiliates (272,917) (142,535) (665,365) Cash distributions from Midwest Wireless Holdings LLC 905,051 869,723 901,295 Cash distributions from other unconsolidated affiliates 239,544 166,292 423,581 Noncash patronage refunds (192,669) (260,233) (270,793) Noncash investment income (48,325) Changes in assets and liabilities net of effects of discontinued operations: Accounts receivable (259,394) (83,043) 812,491 Materials, supplies and inventories 64,449 73,522 (423,436) Other current assets (64,130) (45,234) 116,253 Accounts payable (379,206) 26,074 (166,716) Accrued expenses 547,399 13,317 155,083 Income taxes payable 1,361,111 119,804 335,697 Deferred investment tax credits (18,555) (20,715) (31,399) Deferred income taxes 1,058 155 382,904 Deferred compensation 30,558 44,650 27,458 ------------ ------------ ------------ Net cash provided by operating activities 12,952,565 13,115,903 14,102,645 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property, plant and equipment (3,912,756) (9,265,040) (10,618,722) Sales of marketable securities 3,675,519 Decrease (increase) in construction fund (2,577,844) 97,702 (442,097) Proceeds from sales of cable television systems 1,665,782 Investments in other unconsolidated affiliates (23,191) (50,000) (1,988,606) Purchases of other investments (443,742) (1,301,265) (366,643) Proceeds from other investments 1,538,423 799,880 63,240 Increase in other assets (130,696) (161,417) (135,987) Cash effect of split-up of Alliance Telecommunications Corporation (5,214,465) ------------ ------------ ------------ Net cash used in investing activities (9,098,489) (9,880,140) (9,813,296) CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of notes payable and long-term debt (32,517,635) (6,835,525) (6,523,180) Proceeds from issuance of notes payable and long-term debt 32,810,607 2,954,316 2,201,200 Issuance of common stock 431,243 319,606 549,989 Purchase of stock (17,162) (737,455) (1,267,987) ------------ ------------ ------------ Net cash provided by (used in) financing activities 707,053 (4,299,058) (5,039,978) ------------ ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4,561,129 (1,063,295) (750,629) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 12,020,186 13,083,481 13,834,110 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR $ 16,581,315 $ 12,020,186 $ 13,083,481 ============ ============ ============ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Interest paid $ 4,338,703 $ 5,039,440 $ 5,710,494 Income taxes paid 3,491,394 3,596,254 4,650,094 See notes to consolidated financial statements.
32 HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES --------------------------------------------------- Description of business: Hector Communications Corporation owns a 100% interest in five local exchange telephone subsidiaries and one cable television subsidiary. The Company also owns a 100% interest in Alliance Telecommunications Corporation, which owns and operates four local exchange telephone companies and an engineering company. At December 31, 2003, the Company's subsidiaries provided telephone service to 29,882 access lines in 28 rural communities in Minnesota, Wisconsin and North Dakota and cable television services to 9,109 subscribers in Minnesota and Wisconsin. The Company is also an investor in partnerships and corporations providing wireless telephone and other telecommunications related services. Prior to July 7, 2003 Alliance Telecommunications Corporation ("Alliance") was 68% owned by HCC. ("Golden West") of Wall, South Dakota and Alliance Communications Cooperative, Inc. ("ACCI") of Garretson, South Dakota own the remaining interests in Alliance. Effective July 7, 2003 Alliance was reorganized under Section 355 of the Internal Revenue Code ("the split-up transactions'). In the split-up transactions, Golden West exchanged its minority ownership interest in Alliance for all of the outstanding stock of Sioux Valley Telephone Company, its pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. ACCI exchanged its minority ownership interest in Alliance for all of the outstanding stock of Hills Telephone Company, its pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets (Note 2). The disclosures in the Notes for prior periods have been restated to reflect the Company's continuing operations. Basis of presentation: The Company's operating results for the prior periods have been restated pursuant to the discontinued operations rules of SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" to reflect the effects of the split-up of Alliance Telecommunications Corporation. Certain other amounts in the 2002 and 2001 financial statements have been reclassified to conform to the 2003 financial statement presentation. These reclassifications had no effect on net income or stockholders' equity as previously reported. Principles of consolidation: The consolidated financial statements include the accounts of Hector Communications Corporation and its subsidiaries ("HCC" or the "Company"). All material intercompany transactions and accounts have been eliminated. Regulatory accounting: Accounting practices prescribed by regulatory authorities have been considered in the preparation of the financial statements and formulation of accounting policies for telephone subsidiaries. These policies conform to accounting principles generally accepted in the United States of America as applied to regulated public utilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS 71). Estimates: The presentation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and disclosure of contingent assets and liabilities at the balance sheet date, and the reported amounts of revenues and expenses during the reporting period. The estimates and assumptions used in the accompanying consolidated financial statements are based upon management's evaluation of the relevant facts and circumstances as of the time of the financial statements. Actual results could differ from those estimates. The Company's financial statements are also affected by depreciation rates prescribed by regulators, which may result in different depreciation rates than for an unregulated enterprise. Revenue recognition: Revenues are recognized when earned, regardless of the period in which they are billed. Network access revenues are furnished in conjunction with interexchange carriers and are determined by cost separation studies and nationwide average schedules. Revenues include estimates pending finalization of cost studies. Network access revenues are based upon interstate tariffs filed with the Federal Communications Commission by the National Exchange Carriers Association and state tariffs filed with state regulatory agencies. Management believes recorded revenues are reasonable based on estimates of final cost separation studies, which are typically settled within two years. 33 Income taxes and investment tax credits: The provision for income taxes consists of an amount for taxes currently payable and a provision for tax consequences deferred to future periods. For financial statement purposes, deferred investment tax credits are being amortized as a reduction of the provision for income taxes over the estimated useful lives of the related property, plant and equipment. Net income per share: Basic net income per common share is based on the weighted average number of common shares outstanding during each year. Diluted net income per common share takes into effect the dilutive effect of potential common shares outstanding. The Company's potential common shares outstanding include preferred stock, stock options and warrants. The calculation of the Company's net income per share is included in Exhibit 11 of this form 10-K. Stock compensation: The Company has stock plans under which stock options, stock appreciation rights, restricted stock or deferred stock may be granted to officers, key employees and nonemployee directors. Employees may also participate in an employee stock purchase plan which allows them to purchase shares through payroll deductions on favorable terms. These plans are described more fully in Note 10. The Company has elected to apply APB Opinion No. 25, "Accounting for Stock Issued to Employees" for measurement and recognition of stock-based transactions with its employees and directors. If the Company had elected to recognize compensation cost for its stock-based transactions based on the fair value of the options method prescribed by SFAS No. 123 (see Note 10), net income and net income per share would have been as follows: 2003 2002 2001 ------------ ------------ ------------ Net income as reported $ 5,178,760 $ 508,320 $ 4,616,154 Less: Total stock-based employee compensation expense determined under the fair value method for all awards (472,941) (460,794) (348,388) ------------ ------------ ------------ Pro forma net income $ 4,705,819 $ 47,526 $ 4,267,766 ============ ============ ============ Basic net income per share: As reported $ 1.48 $ .15 $ 1.33 Pro forma $ 1.35 $ .01 $ 1.23 Diluted net income per share: As reported $ 1.37 $ .13 $ 1.23 Pro forma $ 1.25 $ .01 $ 1.13 Cash and cash equivalents: The Company considers temporary cash investments with an original maturity of three months or less to be cash equivalents. Accounts receivable: Receivables are stated at the amount the Company expects to collect from outstanding balances. The Company provides for probable uncollectible amounts through a charge to earnings and a credit to a valuation allowance based on its assessment of the current status of individual accounts. Balances that are still outstanding after the Company has used reasonable collection efforts are written off through a charge to the valuation allowance and a credit to the receivable accounts. Property, plant and equipment: Property, plant and equipment is recorded at cost. Depreciation is computed using principally the straight-line method. Depreciation included in costs and expenses from continuing operations was $7,828,067, $7,986,565 and $7,690,347 for 2003, 2002 and 2001, respectively. . Depreciation included in costs and expenses from discontinued operations was $938,095, $1,975,002 and $1,792,576 for 2003, 2002 and 2001, respectively. Maintenance and repairs are charged to operations and additions or improvements are capitalized. Items of property sold, retired or otherwise disposed of in the ordinary course of business are removed from assets and any gains or losses are included in accumulated depreciation. 34 Goodwill: In July, 2001 the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets". The Company adopted these standards effective January 1, 2002. Under the new standards, goodwill is no longer amortized but is reviewed annually for impairment (Note 4). Prior to the adoption of SFAS No. 142, goodwill was amortized on the straight-line method over periods ranging from fifteen to forty years. Amortization included in costs and expenses from continuing operations was $1,812,679 in 2001. Investments in unconsolidated affiliates: The Company is a co-investor with other rural ILECS in Midwest Wireless Holdings LLC (Note 5) and several other partnerships and limited liability corporations (Note 6). The Company's percentage of ownership in these joint ventures ranges from 5% to 25%. The Company has board of director representation in each of these joint ventures and has the ability to influence their operations. The Company uses the equity method of accounting for these investments, which reflects original cost and recognition of the Company's share of operating income or losses from the respective operations. Other investments: The Company owns Rural Telephone Bank stock, CoBank stock, long-term certificates of deposit, and investments in the stock of other telecommunications service providers. Long-term investments in corporations that are not intended for resale or are not readily marketable and in which the Company does not exercise significant influence are valued at cost, which does not exceed net realizable value. Other assets: Other assets owned by the Company include cable television franchises, customer lists and other deferred charges. In accordance with SFAS 142, intangible assets determined to have an indefinite useful life are not amortized. Intangible assets with a determinable life are amortized over the useful life. Amortization included in expenses from continuing operations was $23,444, $1,085 and $18,060 for 2003, 2002 and 2001, respectively (Note 4). Financial instruments: The fair value of the Company's financial instruments approximates carrying value except for long-term investments in other companies and long-term debt. Other long-term investments are not intended for resale and not readily marketable, thus a reasonable estimate of fair value is not practicable. The fair value of long-term debt (including the current portion) was $62,334,000 and $83,883,000 at December 31, 2003 and 2002, respectively. Fair values were estimated based on current rates offered to the Company for debt with similar terms and maturities. New accounting principles: Effective January 1, 2003 the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset Retirement Obligations". The statement establishes accounting standards for recognition and measurement of a liability for an asset retirement obligation and an associated asset retirement cost. The statement applies to tangible long-lived assets, including individual assets, functional groups of related assets and significant parts of assets. It covers a company's legal obligations resulting from the acquisition, construction, development or normal operation of a capital asset. The FCC has notified the Company's ILEC subsidiaries that SFAS No. 143 will not be adopted for regulatory purposes. Current regulatory accounting requires ILECs to accrue for asset retirement obligations through prescribed depreciation rates. The amount of asset retirement obligations the Company is required to record under SFAS No. 143 is not significant. Adoption of the provisions of SFAS No. 143 did not have a material impact on the Company's financial position or operating results. In November 2002 the Financial Accounting Standards Board ("FASB") issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". This interpretation elaborates on the disclosures required in financial statements concerning obligations under certain guarantees. It also clarifies the requirements related to the recognition of liabilities by a guarantor at the inception of certain guarantees. The disclosure requirements of this interpretation were effective on December 31, 2002, but did not require any additional disclosures on the part of the Company. The recognition provisions of the interpretation effective for 2003 are applicable only to guarantees issued or modified after December 31, 2002. Adoption of these provisions did not have a material impact on the Company's financial position or results of operations. 35 In June 2002 the FASB issued SFAS No.146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." This statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue No. 94-3, a liability for an exit cost was recognized at the date of the entity committed to an exit plan. The provisions of this statement were effective for exit or disposal activities initiated after December 31, 2002. Adoption of SFAS No. 146 did not have a material impact on the Company's financial position or results of operations. In April 2003 the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This statement amends and clarifies accounting and reporting for derivative instruments. SFAS No. 149 is effective for contracts made or modified after June 30, 2003. Adoption of SFAS No. 149 did not have a material effect on the Company's financial position or results of operations. In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equities", which became effective for the Company with this report. Adoption of this statement did not have a material impact on the Company's consolidated results of operations and financial position. In December 2003, the FASB issued a revision of SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits". The statement revises the disclosures required for pension and other post-retirement benefit plans. The new disclosure requirements are reflected in the Company's Notes to Consolidated Financial Statements in this report as appropriate. In December 2003, the FASB issued a revised Financial Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities". FIN No. 46 requires the assets, liabilities and results of operations of variable interest entities to be included in the Company's financial statements if the entities have certain financial characteristics. FIN No. 46 is effective for investments in special-purpose entities for periods ending after December 15, 2003, and for other types of entities for periods ending after March 15, 2004. Adoption of FIN No. 46 did not result in consolidation or change the Company's disclosures for any of the entities in which it maintains investments. NOTE 2 - SPLIT-UP OF ALLIANCE TELECOMMUNICATIONS CORPORATION ------------------------------------------------------------ Effective July 7, 2003, Alliance was reorganized under Section 355 of the Internal Revenue Code. As a result of the split-up transactions, Golden West exchanged its 20% minority ownership interest in Alliance for all of the outstanding stock of Sioux Valley Telephone Company, which included a pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. ACCI exchanged its 12% minority ownership interest in Alliance for all of the outstanding stock of Hills Telephone Company, which included a pro rata share of Alliance's ownership interest in Midwest Wireless Holdings, LLC and certain other Alliance assets. HCC became the 100% owner of all the remaining Alliance operations and assets. The Company's operating results have been restated to separately reflect the continuing and discontinued Alliance operations. The effect of the split-up transactions on recorded assets and liabilities at the split-up date was as follows: 36 Fair value of net assets transferred in split-up transactions $ 12,351,908 Gain on split-up transactions (348,505) Noncash change in recorded assets and liabilities: Property, plant and equipment $ (9,339,881) Excess of cost over net assets acquired (13,315,447) Investment in Midwest Wireless Holdings, LLC (4,500,496) Investments in other unconsolidated affiliates (1,634,126) Other investments (2,209,494) Other assets (122,635) Noncash current assets (1,116,302) Current liabilities 3,597,049 Long-term debt, less current portion 17,018,954 Deferred income taxes 1,387,994 Deferred compensation 308,483 Minority stockholders interest in Alliance Telecommunications Corp. net assets transferred 3,136,963 (6,788,938) ------------ ------------- Cash transferred in split-up transactions $ 5,214,465 ============= Summarized balance sheet information for the discontinued operations that was included in the balance sheet at December 31, 2002 was as follows: Cash $ 2,428,061 Other current assets 1,466,404 Property, plant and equipment, net 10,021,081 Excess of cost over net assets acquired, net 13,315,447 Investment in Midwest Wireless Holdings, LLC 4,262,316 Investments in other unconsolidated affiliates 1,443,496 Other investments 2,502,593 Other assets 121,637 Current liabilities (2,398,781) Long-term debt (17,583,631) Deferred compensation (312,377) Deferred taxes (1,387,286) ------------- Net assets $ 13,878,960 ============= Operating results for the discontinued operations in the respective periods of 2003, 2002 and 2001 were as follows: 37
Six Months Ended Twelve Months Ended June 30 December 31 ----------- --------------------------- 2003 2002 2001 ----------- ----------- ----------- Revenues $ 4,750,877 $ 9,204,856 $ 9,559,675 Operating costs and expenses 2,919,858 5,804,474 5,707,885 ----------- ----------- ----------- Operating income 1,831,019 3,400,382 3,851,790 Other income and (expenses): Interest expense (680,059) (1,269,706) (1,474,380) Income from investments in unconsolidated affilates: Midwest Wireless Holdings, LLC 385,259 666,831 322,291 Other unconsolidated affiliates 176,618 198,846 329,326 Interest and dividend income 45,911 147,547 240,228 ----------- ----------- ----------- Other expense, net (72,271) (256,482) (582,535) Income before income taxes and minority interest 1,758,748 3,143,900 3,269,255 Income tax expense 770,000 1,187,000 1,159,000 ----------- ----------- ----------- Income before minority interest 988,748 1,956,900 2,110,255 Minority interest in discontinued operations of Alliance Telecommunications Corp. (316,399) (626,208) (675,282) Gain on split-up of Alliane Telecommunications Corp., net of income taxes 209,505 ----------- ----------- ----------- Income from discontinued operations $ 881,854 $ 1,330,692 $ 1,434,973 =========== =========== ===========
The Company accounted for this transaction using the purchase method. The Company recognized a gain on the transaction to the extent that the fair value of the assets transferred to Golden West and ACCI exceeded book value. The gain was recorded as follows: Fair value of the Company's 68% ownership interest in assets and liabilities transferred to Golden West and ACCI in split-up transaction $ 12,351,908 Less: Recorded value of assets and liabilities transferred to Golden West and ACCI in split-up transaction (12,003,403) ------------ Gain on disposal before income taxes 348,505 Deferred income tax expense (139,000) ------------ Net gain $ 209,505 ============ The acquisition of the minority interest in Alliance's continuing operations was recorded as follows: Fair value of the Company's 68% ownership interest in assets and liabilities transferred to Golden West and ACCI in split-up transaction $ 12,351,908 Less: Recorded value of minority interest in assets and liabilities of continuing operations, excluding goodwill (3,866,902) ------------ Excess of fair value over book value $ 8,485,006 ============ Excess of fair value over book value allocated to plant assets, net of related deferred taxes $ 576,000 Excess of fair value over book value allocated to goodwill 7,909,006 The allocation of the excess fair value is based on management's best estimate, pending appraisal results. 38 Immediately prior to the split-up Sioux Valley Telephone Company and Hills Telephone Company paid dividends to Alliance totaling $12,849,000. The dividend proceeds were applied to repay a portion of Alliance's acquisition loan from CoBank. Concurrent with the split-up, the balance of Alliance's debt to CoBank and the balance of the Company's debt to Rural Telephone Finance Cooperative ($3,047,000 at June 30, 2003) were retired using proceeds from a new $26,813,000 term loan from CoBank to Hector Communications Corporation. NOTE 3 - PROPERTY, PLANT AND EQUIPMENT -------------------------------------- The cost of property, plant and equipment and the estimated useful lives are as follows: December 31 Estimated ---------------------------- useful life 2003 2002 ------------ ------------- ------------ Land $ 483,371 $ 634,160 Buildings 5-40 years 5,697,302 6,658,469 Machinery and equipment 3-15 years 3,431,762 4,032,923 Furniture and fixtures 5-10 years 2,008,349 2,221,407 Telephone plant 5-33 years 76,879,020 91,153,581 Cable television plant 10-15 years 9,010,989 10,445,523 Construction in progress 663,753 400,533 ------------ ------------ 98,174,546 115,546,596 Less accumulated depreciation 55,086,440 58,880,798 ------------ ------------ $ 43,088,106 $ 56,665,798 ============ ============ NOTE 4 - GOODWILL AND INTANGIBLE ASSETS --------------------------------------- Effective January 1, 2002 the Company adopted SFAS No. 142, "Goodwill and Other Intangible Assets". Under the provisions of this accounting standard, goodwill and intangible assets with indefinite useful lives are no longer amortized but are instead tested for impairment on at least an annual basis. At December 31, 2001 the Company had excess of cost over net assets acquired or "goodwill" of $53,663,000, which was net of an amortization reserve of $10,025,000. The Company determined that these assets have indefinite useful lives and ceased amortization effective January 1, 2002. During the first half of 2002, the Company tested the beginning value of its goodwill and intangible assets as required by SFAS No. 142. As a result of this test, the Company concluded that the carrying value of the goodwill and intangible assets in certain of its operating units exceeded the market value. Accordingly, the Company recognized an impairment loss and reduced its goodwill and intangible assets by $4,663,000. After income tax benefits of $121,000 and minority interest of $1,395,000, the charge against earnings was $3,147,000 which was recognized as a cumulative effect of change in accounting principle and carried back to the first quarter of 2002. In calculating the impairment charge, the fair value of the impaired reporting units underlying the segments were estimated using used the same valuation methodology the Company used to negotiate the breakup of Alliance. The valuation is an average of access line and customer valuations and cash flow multiple valuations considered appropriate in the current marketplace. The Company believes the valuations placed on these units are consistent with values placed on properties in recent comparable transactions and that valuation of the reporting units using different methods would have yielded similar results. The goodwill impairment is associated principally with goodwill resulting from the Company's acquisition of Hager TeleCom, Inc, but also included charges from cable television acquisitions and the acquisition of Ollig Utilities. The amount of the impairment primarily reflects the decline in the market valuations for telephone access lines and internet customers and valuations of competing local exchange carrier ("CLEC") assets that have occurred since the acquisition. For 2003, the Company performed its annual impairment test of goodwill during the third quarter. The determined fair value was sufficient to pass the impairment test, and no impairment was recorded. Changes in the Company's goodwill by segment are as follows: 39
Hector Alliance Consolidated ----------------- ---------------- ---------------- Balance December 31, 2001 $ 623,721 $ 53,039,029 $ 53,662,750 Impairment loss (228,447) (4,359,310) (4,587,757) ----------------- ---------------- ---------------- Balance December 31, 2002 395,274 48,678,719 49,074,993 Cable television system sales (970,673) (970,673) Split-up of Alliance Telecommunications Corporation: Goodwill included in discontinued operations (13,315,447) (13,315,447) Eliminate previously recorded goodwill related to the minority interest acquired (11,005,952) (11,005,952) Excess fair value allocated to goodwill in acquisition of minority interest 7,909,006 7,909,006 ----------------- ---------------- ---------------- Balance December 31, 2003 $ 395,274 $ 31,296,653 $ 31,691,927 ================= ================ ================
The Company's other intangible assets consist of deferred loan origination fees, cable television franchises and internet customer lists. Amortization expense for the next five years is estimated as follows: 2004 - $38,900, 2005 - $38,900, 2006 - $38,400, 2007 - $36,000, 2008 - $17,200. At December 31, 2001, the Company had an investment in cable television franchises of $77,000, net of an amortization reserve of $146,000. Under the provisions of SFAS 142, the Company determined its cable television franchises have an indefinite useful life and ceased amortization effective January 1, 2002. Cable television franchises are limited to 15 years, but are renewable as long as the Company continues to comply with the applicable Federal Communications Commission (FCC) rules and policies and the terms of the local franchising authorities. Franchises may be renewed at minimal cost. The Company intends to renew the franchises indefinitely, and has had no problems obtaining necessary renewals. The Company will evaluate each reporting period whether events and circumstances continue to support an indefinite useful life for the franchises. Changes in the Company's intangible assets by segment are as follows:
Hector Alliance ----------- ---------------------------- Intangible Intangible Assets Assets Other Assets Consolidated ------------ ------------ ------------ ------------ Balance at December 31, 2001 $ 77,060 $ - $ 250,625 $ 327,685 Additions 7,700 98,358 54,123 160,181 Amortization (1,085) - - (1,085) Impairment loss (75,282) - - (75,282) ------------ ------------ ------------ ------------ Balance at December 31, 2002 8,393 98,358 304,748 411,499 Additions 167,845 167,845 Disposals (14,993) (14,993) Amortization (10,592) (21,460) (32,052) Distributed in Alliance split-up (122,635) (122,635) ------------ ------------ ------------ ------------ Balance at December 31, 2003 $ 165,646 $ 76,898 $ 167,120 $ 409,664 ============ ============ ============ ============
The following table provides a reconciliation of reported net income to pro forma net income, including net income per share information, for the periods ended December 31, 2003, 2002 and 2001 as if the provisions of SFAS 142 had been effective January 1, 2001: 40 2003 2002 2001 ----------- ----------- ----------- Net income as reported $ 5,178,760 $ 508,320 $ 4,616,154 Amortization 1,833,851 Midwest Wireless amortization 468,609 Midwest Wireless goodwill 252,780 Income tax expense (289,000) Minority interest (669,282) ----------- ----------- ----------- Pro forma net income $ 5,178,760 $ 508,320 $ 6,213,112 =========== =========== =========== Basic net income per share: As reported $ 1.48 $ .15 $ 1.33 Pro forma $ 1.48 $ .15 $ 1.79 Diluted net income per share As reported $ 1.37 $ .13 $ 1.23 Pro forma $ 1.37 $ .13 $ 1.65 NOTE 5 - MIDWEST WIRELESS HOLDINGS LLC -------------------------------------- At December 31, 2003 the Company owned 8.0% of Midwest Wireless Holdings LLC, which provides cellular service to rural service areas in Minnesota, Wisconsin and Iowa and the Rochester, Minnesota MSA. The Company actively participates in Midwest Wireless' operations and has had a seat on the Board of Directors since the inception of the Company. The Company influences Midwest Wireless policies and procedures applying to administration, planning and budgeting, cell siting, technology selection, roaming agreements, affiliation agreements, marketing and customer service, financing, accounting policies and financial reporting and disclosure policies and the timing of financial reports. The Company's ownership is recorded on the equity method of accounting, which reflects original cost and recognition of the Company's share of income or losses. The excess of cost over the Company's share of equity in Midwest Wireless at the time of acquisition was $5,595,000 at December 31, 2003. Excess cost was amortized in 2001 on the straight-line method over periods ranging from twenty-five to forty years. Amortization expense was $179,000 in 2001. At December 31, 2003, the Company's cumulative share of income from Midwest Wireless was $10,692,000, of which $6,468,000 was undistributed. Midwest Wireless has loan agreements with the Rural Telephone Finance Cooperative ("RTFC") that restrict distributions to members. At December 31, 2003, under these covenants Midwest Wireless could not make distributions to members except for amounts necessary to pay income taxes. Summarized audited financial information for Midwest Wireless for 2003, 2002 and 2001 is as follows: Year Ended December 31 2003 2002 2001 --------------- -------------- -------------- Current assets $ 15,927,067 $ 12,445,979 $ 17,409,300 Noncurrent assets 360,331,919 305,838,514 285,615,880 Current liabilities 36,133,737 56,909,149 48,394,693 Noncurrent liabilities 172,862,375 115,446,843 130,528,309 Minority interest 11,617,812 9,428,619 6,913,996 Members' equity 155,645,062 136,499,882 117,188,182 Revenues 179,563,840 162,697,183 140,538,515 Expenses 152,868,437 134,583,663 123,950,155 Net income 26,695,403 28,113,520 16,588,360 41 NOTE 6 - INVESTMENTS IN UNCONSOLIDATED AFFILIATES ------------------------------------------------- The Company is a co-investor with other rural ILECS in several other partnerships and limited liability corporations. These joint ventures make it possible to offer certain services to customers, including centralized switching or fiber optic transport of messaging, that the Company could not afford to offer on its own. These joint ventures also make it possible to invest in new technologies with a lower level of financial risk. The Company recognizes income and losses from these investments on the equity method of accounting. The following table summarizes the Company's ownership percentage, current investment and income or loss from these investments in 2003, 2002 and 2001:
Book Value at December 31 Income (Loss) on Investment Ownership -------------------------- ----------------------------------------- Interest 2003 2002 2003 2002 2001 ---------- ----------- ----------- --------- --------- --------- Broadband Visions 17.3% $ 683,973 $ 698,155 $ (14,182) $ (2,190) $ (949) Communications Mgmt Grp 6.5% 196,300 176,242 20,058 (7,172) (56,134) Desktop Media 10.0% 159,964 375,000 (167,036) (125,000) Northern Transport Group 20.0% 314,579 353,439 (38,860) (40,621) 121,204 NW Minnesota Spec Access 5.3% 67,725 88,612 19,113 16,032 53,232 South Central Switching 25.0% 101,399 1,894 13,039 41,906 Val-Ed Joint Venture 18.1% 1,151,302 923,561 236,813 28,838 150,671 West Central Transport 5.0% 222,192 213,693 38,499 60,763 53,533 Wireless North 10.4% - - (27,424) ----------- ----------- --------- --------- --------- Investments owned by continuing operations 2,796,035 2,930,101 96,299 (56,311) 336,039 Investments owned by discontinued operations 1,443,496 176,618 198,846 329,326 ----------- ----------- --------- --------- --------- $ 2,796,035 $ 4,373,597 $ 272,917 $ 142,535 $ 665,365 =========== =========== ========= ========= =========
NOTE 7 - MARKETABLE SECURITIES AND GAINS ON SALES OF INVESTMENTS ---------------------------------------------------------------- Marketable securities consist principally of equity securities of other telecommunications companies obtained by the Company's subsidiaries in sales of investments in wireless telephone partnerships. The Company's marketable securities portfolio was classified as available-for-sale at December 31, 2003 and December 31, 2002. The cost and fair values of available-for-sale investment securities were as follows: Gross Gross Unrealized Unrealized Fair Cost Gains Losses Value --------- --------- --------- --------- December 31, 2003 $ 126,482 $ 100,529 $ (15,165) $ 211,846 December 31, 2002 $ 126,482 $ 21,292 $ (33,540) $ 114,234 Net unrealized gains on marketable securities, net of related deferred taxes and minority interest, are included in stockholders' equity as accumulated other comprehensive income (loss) at December 31, 2003 and 2002 as follows: Net Deferred Accumulated Unrealized Income Minority Comprehensive Gains(Losses) Taxes Interest Income(Loss) --------- --------- --------- --------- December 31, 2003 $ 85,364 $ (34,139) $ - $ 51,225 December 31, 2002 $ (12,248) $ 4,914 $ (3,783) $ (11,117) These amounts have no cash effect and are not included in the statement of cash flows. During 2002 the Company determined that its investment in certain available-for-sale securities was permanently impaired. Due to the impairment, the Company reduced the cost basis of its marketable securities by $134,500 and recorded a charge against net income. 42 Gross proceeds from sales of available-for-sale securities were $3,676,000 in 2001. Gross realized gains on sales of securities were $3,659,000 in 2001. Realized gains on sales are based on the difference between net sales proceeds and the book value of the securities sold, using the specific identification method. NOTE 8 - INCOME TAXES --------------------- Before completion of the split-up of Alliance Telecommunications Corporation, Hector Communications Corporation and its wholly owned subsidiaries filed a consolidated tax return separate from the consolidated return for Alliance and its subsidiaries. Since the split-up date all subsidiary companies are included in Hector's consolidated return. Income tax expenses (benefits) from continuing operations on the last three years were: Year Ended December 31 ----------------------------------------- 2003 2002 2001 ----------- ------------ ----------- Currently payable taxes: Federal $ 2,434,000 $ 1,483,000 $ 3,154,000 State 1,039,000 803,000 943,000 ----------- ----------- ----------- 3,473,000 2,286,000 4,097,000 Deferred income taxes (benefit) (138,000) 218,000 96,000 Deferred investment tax credits (19,000) (21,000) (31,000) ----------- ----------- ----------- $ 3,316,000 $ 2,483,000 $ 4,162,000 =========== =========== =========== Deferred tax assets and liabilities as of December 31 related to the following: 2003 2002 ----------- ----------- Deferred tax liabilities: Accelerated depreciation $ 4,766,870 $ 6,158,754 Partnership and LLC investments 1,329,000 903,000 Marketable securities 39,000 1,000 Other 137,000 - ----------- ----------- 6,271,870 7,062,754 Deferred tax assets: Deferred compensation 274,000 376,000 Intangibles 200,000 238,000 Accrued expenses 261,000 272,000 Bad debts 213,000 255,000 Other 421,000 55,000 ----------- ----------- 1,369,000 1,196,000 ----------- ----------- Net deferred tax liability $ 4,902,870 $ 5,866,754 =========== =========== The provision for income taxes varied from the federal statutory tax rate as follows: Year Ended December 31 --------------------------- 2003 2002 2001 ------- ------- ------- Tax at U.S. statutory rate 35.0% 35.0% 35.0% Surtax exemption (.9) (1.0) (1.0) State income taxes, net of federal benefit 6.2 11.5 7.7 Excess of cost over net assets acquired - - 7.1 Investment tax credits (.2) (.4) (.4) Other - (.7) 1.0 ------- ------- ------- Effective tax rate 40.1% 44.4% 49.4% ======= ======= ======= 43 NOTE 9 - NOTES PAYABLE AND LONG-TERM DEBT -----------------------------------------
December 31 ------------------------------ 2003 2002 ------------ ------------ Notes payable to CoBank by Hector Communications Corporation in quarterly installments, average interest rate of 4.4%, due 2004 to 2013 $ 26,125,000 Notes payable to CoBank by Alliance Telecommunications Corporation $ 38,186,000 Rural Utilities Service ("RUS") and Rural Telephone Bank ("RTB") mortgage notes, payable by telephone company subsidiaries in monthly and quarterly installments, average rate of 5.0%, due 2004 to 2028 37,239,260 39,953,618 Notes payable to Rural Telephone Finance Cooperative 3,157,051 Notes payable to former owners of Felton Telephone Company by Hector Communications Corporation in monthly installments, interest rate of 8.25%, due 2005 702,918 1,215,491 ------------ ------------ 64,067,178 82,512,160 Less current portion 6,537,800 7,364,600 ------------ ------------ $ 57,529,378 $ 75,147,560 ============ ============
The Rural Utilities Service (RUS) and the Rural Telephone Bank (RTB) are the Company's primary sources of long-term financing for additions to telephone plant and equipment. The RUS has made long-term, low-interest loans to telephone companies since 1949 for the purpose of improving telephone service in rural areas. The RUS is authorized to make hardship loans at a 5% interest rate and cost-of-money loans at a rate reflecting the government's cost of money for a like term. The RTB advances funds at the average U.S. government cost-of-money for the year for like maturities. In some cases RTB loans are made concurrently with RUS loans. Substantially all of the telephone plant of the LEC subsidiaries is pledged or is subject to mortgages to secure obligations to the RUS and RTB. At December 31, 2003, the Company's local exchange carrier subsidiaries had unadvanced loan commitments under the RUS and RTB programs aggregating approximately $13,299,000 to finance specific construction activities in future years. Alliance had a term loan agreement with CoBank which was used to fund the acquisition of Ollig Utilities Company. As part of the Alliance split-up transaction, the original acquisition loan was repaid with funds from a new term loan to HCC from CoBank. As a condition of maintaining the loan, the Company owns stock in the bank. At December 31, 2003, investment in CoBank stock was $2,555,000. CoBank is a cooperative, owned and controlled by its customers. Each customer borrowing from the bank on a patronage basis shares in the bank's net income through payment of patronage refunds. Patronage refunds included in continuing operations were $219,000, $194,000 and $210,000 in 2003, 2002 and 2001, respectively. Approximately 50% of patronage refunds are received in cash, with the balance in stock in the bank. The accrued patronage refund is reflected in the Company's operating statement as a reduction of interest expense. The Company cannot predict what patronage refunds might be in future years. Pledges of the parent company assets and the stock of the Company's subsidiaries secure CoBank's loan. Interest rates on long-term portions of the loan are fixed through 2007, while the non-fixed portion floats at short-term market rates. The average rate on the total loan was approximately 4.4% at December 31, 2003. Principal payments are made quarterly and will continue until April 2013. The amount of dividends on common stock that may be paid by the subsidiaries to the Company is limited by certain financial covenants set forth in the RUS, RTB and CoBank mortgages. At December 31, 2003, $11,863,000 of subsidiaries' retained earnings was available for dividend payments to HCC. At December 31, 2003, $32,614,000 of HCC's retained earnings were not available to pay dividends to shareholders due to restrictions in the debt agreements. 44 The Company is continuing its construction program to upgrade its telephone and cable television properties. Planned expenditures for HCC and Alliance properties in 2004 are $4,387,000. The Company intends to use RUS and RTB loan funds to help finance these projects. Loan funds received are deposited in construction fund accounts and disbursements are restricted, subject to RUS approval, to construction costs authorized by the loan agreements. Until July 7, 2003 the Company had a term loan and a $5,000,000 revolving line of credit from Rural Telephone Finance Cooperative ("RTFC"). Part of the proceeds of the Company's new term loan from CoBank was used to repay the RTFC loan and terminate the revolving line of credit. The annual requirements for principal payments on notes payable and long-term debt are as follows: 2004 $ 6,537,800 2005 6,340,900 2006 6,451,800 2007 6,650,000 2008 6,847,700 NOTE 10 - STOCKHOLDERS' EQUITY ------------------------------ Preferred stock is entitled to share ratably with common shareholders in any dividends or distributions paid by the Company, but are not entitled to any dividend distribution separate from common shareholders. Preferred shareholders have no voting rights. Each share of preferred stock is convertible into one share of common stock. Common shares are reserved for issuance in connection with stock option plans under which 1,100,000 shares may be issued pursuant to stock options, stock appreciation rights, restricted stock or deferred stock granted to officers and key employees. Exercise prices of stock options under the plan cannot be less than fair market value of the stock on the date of grant. Rules and conditions governing awards of stock options, stock appreciation rights and restricted or deferred stock are determined by the Compensation Committee of the Board of Directors, subject to certain limitations incorporated into the plan. Another provision of the plans automatically grants 3,000 shares of nonqualified stock options per year to each nonemployee director. Options issued under this provision have a ten-year term and an exercise price not less than fair market value at date of grant. At December 31, 2003, 273,833 shares were available to be issued under the plans. Changes in outstanding employee and director stock options during the three years ended December 31, 2003 are as follows: Average Number of exercise price shares per share ------- --------- Outstanding at December 31, 2000 349,075 $ 9.83 Granted 105,550 10.28 Exercised (64,800) 7.79 Canceled (750) 10.84 ------- --------- Outstanding at December 31, 2001 389,075 10.29 Granted 111,800 13.27 Exercised (53,800) 8.24 Canceled (900) 11.91 ------- --------- Outstanding at December 31, 2002 446,175 11.28 Granted 115,850 12.18 Exercised (67,125) 10.22 Canceled (23,583) 11.86 ------- --------- Outstanding at December 31, 2003 471,317 $ 11.62 ======= ========= Options issued to officers and key employees are subject to vesting. Options are vested and become exercisable one-third at the date of issue, one-third one year from date of issue and one-third two years from date of issue. At December 31, 2003, 373,800 stock options are currently exercisable at an average price of $11.42 per share. The following table summarizes the status of stock options outstanding at December 31, 2003 : 45 Weighted Average Weighted Remaining Average Range of Exercise Prices Shares Option Life Exercise Price ------------------------ -------- ----------- -------------- $ 6.87 to $ 9.99 48,800 .6 years $ 8.57 $10.00 to $12.00 265,267 2.9 years 11.22 $12.01 to $14.43 157,250 4.4 years 13.26 At the 2003 Annual Meeting shareholders adopted the 2003 Employee Stock Purchase Plan ("ESPP"), for which 100,000 shares are reserved. Under terms of the plan, eligible employees may acquire shares of common stock through payroll deductions of not more than 10% of compensation. The price of shares purchased by the employees is 85% of the lower of fair market value for such shares on one of two specified dates in each plan year. A participant is limited to the acquisition in any plan year to the number of shares which their payroll deductions for the year would purchase based on the market price on the first day of the year or $25,000, whichever is less. At December 31, 2003 employees had subscribed to purchase an additional 12,400 shares in the current plan cycle ending August 31, 2004. Shares issued to employees under the 1990 Employee Stock Purchase Plan were 15,685, 11,578 and 11,626 for the plan years ended August 31, 2003, 2002 and 2001, respectively. The Company has adopted the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", but applies APB Opinion No. 25, "Accounting for Stock Issued to Employees" for measurement and recognition of stock-based transactions with its employees. If the Company had elected to recognize compensation cost for its stock based transactions using the method prescribed by SFAS No. 123, net income and earnings per share would have been as follows: Year Ended December 31 --------------------------------------------- 2003 2002 2001 ----------- ----------- ----------- Net income $ 4,705,819 $ 47,526 $ 4,267,766 Basic net income per share $ 1.35 $ .01 $ 1.23 Diluted net income per share $ 1.25 $ .01 $ 1.13 The fair value of the Company's stock options and Employee Stock Purchase Plan transactions used to compute pro forma net income and net income per share disclosures is the estimated present value at grant date using the Black-Scholes option-pricing model. The following table displays the assumptions used in the model: Year Ended December 31 -------------------------------------- 2003 2002 2001 ---------- ---------- ---------- Expected volatility 29.6% 29.8% 29.3% Risk free interest rate 2.9% 4.6% 4.7% Expected holding period - employees 4 years 4 years 4 years Expected holding period - directors 7 years 7 years 7 years Dividend yield 0% 0% 0% Pro forma stock-based compensation cost was $472,941, $460,794 and $348,388 in 2003, 2002 and 2001, respectively. Fair value of all options issued was $453,450, $515,360 and $358,950 in 2003, 2002 and 2001, respectively. The Company's Board of Directors has authorized the purchase and retirement, from time to time, of shares of the Company's stock on the open market, or in private transactions consistent with overall market and financial conditions. The Company purchased and retired 1,106, 70,239 and 109,704 shares in 2003, 2002 and 2001 respectively. Cost of the repurchased shares was $17,000, $737,000 and $1,268,000 in 2003, 2002 and 2001 respectively. At December 31, 2003, 215,000 shares could be repurchased under outstanding Board authorizations. Effective August 1, 1990, the Board of Directors adopted an employee stock ownership plan ("ESOP"). Contributions to the ESOP are determined by the Board on an annual basis and can be made in cash or by issuing shares of the Company's common stock. ESOP expense reflects the market value of company stock contributed to the accounts of eligible employees at the time of the contribution. ESOP expense was $284,600, $139,200 and $133,200 for 2003, 2002 and 2001, respectively. At December 31, 2003, the ESOP held 86,138 shares of the 46 Company's common stock, all of which had been allocated to the accounts of participating employees. All eligible employees of Hector Communications Corporation and its subsidiaries participate in the plan after completing one year of service. Employees of Alliance Telecommunications Corporation did not participate in the plan in 2002 and 2001. Contributions are allocated to each participant based on compensation and vest 30% after three years of service and incrementally thereafter, with full vesting after seven years. In 1999 the Board of Directors adopted a shareholders' rights plan. Under the plan, the Board of Directors declared a distribution of one right per share of common stock. Each right entitles the holder to purchase 1/100th of a share of a new series of Junior Participating Preferred Stock of the Company at an initial exercise price of $65. The rights expire on July 27, 2009. The rights will become exercisable only following the acquisition by a person or group, without the prior consent of the Board of Directors, of 15% or more of the Company's voting stock, or following the announcement of a tender offer or exchange offer to acquire an interest of 15% or more. If the rights become exercisable, each rightholder will be entitled to purchase, at the exercise price, common stock with a market value equal to twice the exercise price. Should the Company be acquired, each right would entitle the holder to purchase, at the exercise price, common stock of the acquiring company with a market value equal to twice the exercise price. Any rights owned by the acquiring person or group would become void. NOTE 11 - EMPLOYEE BENEFIT PLANS The Company has 401(k) savings plans for its employees. Employees who meet certain age and service requirements may contribute up to 15% of their salaries to the plan on a pretax basis. The Company matches a portion of employee contributions. Contributions to the plan by the Company's continuing operations for 2003, 2002 and 2001 were approximately $166,000, $181,000 and $178,000 respectively. In 2002 and 2001, employees of Alliance who met certain age and service requirements were eligible to participate in a profit sharing plan. The plan was terminated in 2003 and employees of Alliance's continuing operations now participate in the Company's ESOP. Contributions to the plan by the Company's continuing operations in 2002 and 2001 were $235,000 and $207,000 respectively. Alliance had a deferred compensation agreement with two former officers of Ollig Utilities, Inc. Under the agreement, the salaries of these officers were continued after their retirement based on a formula stated in the agreement. Under the terms of the split-up agreement, the Company is responsible for 68% of the remaining deferred compensation, Golden West is responsible for 20% and ACCI is responsible for 12%. Deferred compensation expense included in continuing operations under the plan was $98,000, $94,000 and $82,000 in 2003, 2002 and 2001 respectively. Payments made under the agreement by the Company's continuing operations were $63,000 in each of the last three years. NOTE 12 - TRANSACTIONS WITH COMMUNICATIONS SYSTEMS, INC. Transactions between the Company and Communications Systems, Inc. (CSI), the Company's former parent, are based on a distribution agreement, which provides for the Company's use of certain of CSI's staff and facilities, with related costs paid by the Company. Services provided by CSI aggregated approximately $208,000, $186,000 and $286,000 in 2003, 2002 and 2001 respectively. Costs of services from CSI may not be indicative of the costs of such services had they been obtained from a different party. Intercompany accounts with CSI are handled on an open account basis. Outstanding amounts payable to CSI were $229,000 and $74,000 at December 31, 2003 and 2002, respectively. NOTE 13 - SEGMENT INFORMATION The Company is organized into two business segments: Hector Communications Corporation and its subsidiaries, and Alliance Telecommunications Corporation and its subsidiaries. No single customer accounted for a material portion of the Company's revenues in any of the last three years. Segment information is as follows: 47
Hector Alliance Consolidated -------------- -------------- --------------- Year Ended December 31, 2003 ---------------------------- Revenues from continuing operations $ 9,954,322 $ 22,368,106 $ 32,322,428 Costs and expenses 8,166,569 16,199,213 24,365,782 -------------- -------------- --------------- Operating income from continuing operations 1,787,753 6,168,893 7,956,646 Interest expense (1,420,001) (1,981,478) (3,401,479) Income from unconsolidated affiliates: Midwest Wireless Holdings LLC 803,096 1,345,348 2,148,444 Other unconsolidated affiliates 26,991 69,308 96,299 Interest and dividend income 110,994 280,903 391,897 Gain on sale of cable television systems 1,080,723 1,080,723 -------------- -------------- --------------- Income from continuing operations before income taxes and minority interest $ 1,308,833 $ 6,963,697 $ 8,272,530 ============== ============== =============== Depreciation and amortization: Continuing operations $ 2,993,511 $ 4,858,000 $ 7,851,511 Continuing operations - charged to interest expense 8,607 201 8,808 Discontinued operations 938,095 938,095 -------------- -------------- --------------- $ 3,002,118 $ 5,796,296 $ 8,798,414 ============== ============== =============== Total assets $ 38,256,910 $ 84,802,445 $ 123,059,355 ============== ============== =============== Capital expenditures: Continuing operations $ 1,397,656 $ 2,258,205 $ 3,655,861 Discontinued operations 256,895 256,895 -------------- -------------- --------------- $ 1,397,656 $ 2,515,100 $ 3,912,756 ============== ============== =============== Year Ended December 31, 2002 ---------------------------- Revenues from continuing operations $ 9,466,013 $ 21,050,777 $ 30,516,790 Costs and expenses 8,541,209 15,334,210 23,875,419 -------------- -------------- --------------- Operating income from continuing operations 924,804 5,716,567 6,641,371 Interest expense (891,553) (2,565,540) (3,457,093) Income from unconsolidated affiliates: Midwest Wireless Holdings LLC 844,403 1,417,017 2,261,420 Other unconsolidated affiliates 46,892 (103,203) (56,311) Interest and dividend income 135,169 198,542 333,711 Loss on marketable securities (134,498) (134,498) -------------- --------------- ---------------- Income from continuing operations before income taxes and minority interest $ 1,059,715 $ 4,528,885 $ 5,588,600 ============== ============== =============== Depreciation and amortization: Continuing operations $ 3,139,678 $ 4,847,972 $ 7,987,650 Continuing operations - charged to interest expense 1,236 1,236 Discontinued operations 1,975,002 1,975,002 -------------- -------------- --------------- $ 3,139,678 $ 6,824,210 $ 9,963,888 ============== ============== =============== Total assets: Continuing operations $ 30,564,628 $ 88,537,026 $ 119,101,654 Discontinued operations 35,384,306 35,384,306 -------------- -------------- --------------- $ 30,564,628 $ 123,921,332 $ 154,485,960 ============== ============== =============== Capital expenditures: Continuing operations $ 2,608,523 $ 5,120,598 $ 7,729,121 Discontinued operations 1,535,919 1,535,919 -------------- -------------- --------------- $ 2,608,523 $ 6,656,517 $ 9,265,040 ============== ============== ===============
48
Hector Alliance Consolidated -------------- -------------- ---------------- Year Ended December 31, 2001 Revenues from continuing operations $ 9,807,109 $ 21,266,128 $ 31,073,237 Costs and expenses 8,167,467 16,236,544 24,404,011 -------------- -------------- ---------------- Operating income from continuing operations 1,639,642 5,029,584 6,669,226 Interest expense (903,875) (2,923,803) (3,827,678) Income from unconsolidated affiliates: Midwest Wireless Holdings LLC 467,708 684,866 1,152,574 Other unconsolidated affiliates 93,581 242,458 336,039 Interest and dividend income 263,542 168,814 432,356 Gain on sale of marketable securities 3,659,055 3,659,055 -------------- -------------- ---------------- Income from continuing operations before income taxes and minority interest $ 1,560,598 $ 6,860,974 $ 8,421,572 ============== ============== ================ Depreciation and amortization: Continuing operations $ 3,178,259 $ 6,342,827 $ 9,521,086 Continuing operations - charged to interest expense 1,236 1,236 Discontinued operations 1,795,688 1,795,688 -------------- -------------- --------------- $ 3,178,259 $ 8,139,751 $ 11,318,010 ============== ============== =============== Total assets: Continuing operations $ 31,030,867 $ 91,296,203 $ 122,327,070 Discontinued operations 35,923,983 35,923,983 -------------- -------------- --------------- $ 31,030,867 $ 127,220,186 $ 158,251,053 ============== ============== =============== Capital expenditures: Continuing operations $ 3,984,562 $ 4,634,739 $ 8,619,301 Discontinued operations 1,999,421 1,999,421 -------------- -------------- --------------- $ 3,984,562 $ 6,634,160 $ 10,618,722 ============== ============== ===============
NOTE 14 - SALES OF CABLE TELEVISION SYSTEMS Alliance completed sales of two groups of cable television systems during the second quarter of 2003. Alliance sold four systems in rural North Dakota serving 930 subscribers to MLGC, LLC for $200,000 of cash and a note receivable of $650,000. Alliance sold systems serving 1,150 subscribers in three communities surrounding the Fargo, ND - Moorhead, MN area to Cable One, Inc. for $1,545,000 of cash (including $80,000 of escrowed funds). Effect of the asset sales was as follows: Sales Price $ 2,395,032 Less: Property, plant and equipment (net) (343,636) Less: Intangible assets (goodwill) (970,673) ----------------- Gain on sale of cable assets $ 1,080,723 ================= 49 (b) SUPPLEMENTAL FINANCIAL INFORMATION Unaudited Quarterly Operating Results (in thousands except per share amounts)
Quarter Ended March 31 June 30 Sept 30 Dec 31 ------------------------------------------------------------------------------------------------------------------ 2003 Revenues from continuing operations $ 8,033 $ 8,054 $ 8,107 $ 8,128 Operating income from continuing operations 1,832 1,820 2,120 2,184 Income from continuing operations 732 1,290 1,008 1,267 Income from discontinued operations 395 278 209 Net income 1,127 1,568 1,217 1,267 Basic net income per share: Continuing operations $ .21 $ .37 $ .29 $ .36 Discontinued operations .11 .08 .06 --------- --------- --------- -------- $ .32 $ .45 $ .35 $ .36 ======== ========= ========= ======== Diluted net income per share: Continuing operations $ .20 $ .34 $ .27 $ .33 Discontinued operations .10 .08 .05 --------- --------- --------- -------- $ .30 $ .42 $ .32 $ .33 ======== ========= ========= ======== 2002 Revenues from continuing operations $ 7,544 $ 7,223 $ 8,299 $ 7,451 Operating income from continuing operations 1,795 1,170 2,629 1,047 Income from continuing operations 755 365 1,087 118 Income from discontinued operations 330 372 242 386 Income before cumulative effect of change in accounting principle 1,085 737 1,329 504 Cumulative effect of change in accounting principle (3,147) Net income (loss) (2,062) 737 1,329 504 Basic net income (loss) per share: Continuing operations $ .22 $ .10 $ .31 $ .03 Discontinued operations .09 .11 .07 .11 Cumulative effect of accounting change (.90) --------- --------- --------- -------- $ (.59) $ .21 $ .38 $ .14 ========= ========= ========= ======== Diluted net income (loss) per share: Continuing operations $ .20 $ .09 $ .29 $ .03 Discontinued operations .09 .10 .06 .11 Cumulative effect of accounting change (.84) --------- --------- --------- -------- $ (.55) $ .19 $ .35 $ .14 ========= ========= ========= ========
50 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES The Company, with the participation of management, including the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures are designed to provide a reasonable level of assurance that information required to be disclosed in the Company's reports under the Securities Exchange Act of 1934 is recorded and reported within the appropriate time periods. Based upon that evaluation, the CEO and CFO concluded that the Company's disclosure controls and procedures are effective. During the period covered by this report, there have been no changes in internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Company's internal control over financial reporting. 51 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by paragraphs (a), (c), (d), (e), and (f) of Item 401 under Regulation S-K, to the extent applicable, will be set forth under the caption "Election of Directors" in the Company's definitive proxy material for its May 20, 2004 Annual Meeting of Shareholders to be filed within 120 days from the end of the Registrant's fiscal year, which information is expressly incorporated by reference herein. The information called for by paragraph (b) of Item 401 is set forth under Item 1(a)(c) herein. The information called for by Item 405 under Regulation S-K, to the extent applicable, will be set forth under the caption "Certain Transactions" in the Company's above referenced definitive proxy material. Code of Ethics The Company has adopted a Code of Ethics and Business Conduct applicable to all officers of the Company as well as certain other key accounting personnel. A copy of the Code of Ethics can be obtained free of charge upon written request directed to HCC's Assistant Secretary at the executive offices of the Company. ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 402 under Regulation S-K to the extent applicable, will be set forth under the caption "Executive Compensation" in the Company's definitive proxy materials for its May 20, 2004 Annual Meeting to be filed within 120 days from the end of the Registrant's fiscal year, which information is expressly incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by Item 403 under Regulation S-K will be set forth under the captions "Security Ownership of Certain Beneficial Owners and Management" and "Election of Directors" in the Company's definitive proxy materials for its May 20, 2004 Annual Meeting to be filed within 120 days from the end of the Registrant's fiscal year, which information is expressly incorporated herein by reference. In addition, the information required by Item 201(d) of Regulation S-K appears herein under Item 5(d). ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 404 under Regulation S-K will be set forth under the caption "Certain Transactions" in the Company's definitive proxy materials for its May 20, 2004 Annual Meeting to be filed within 120 days from the end of the Registrant's fiscal year, which information is expressly incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information called for will be set forth under the caption "The Company's Auditors" in the Company's definitive proxy materials for its May 20, 2004 Annual Meeting to be filed within 120 days from the end of the Registrant's fiscal year, which information is expressly incorporated herein by reference. 52 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K (a) (1) Consolidated Financial Statements The following Consolidated Financial Statements of Hector Communications Corporation and subsidiaries appear at pages 27 to 49 herein: Independent Auditors' Report for the years ended December 31, 2003, 2002 and 2001 Consolidated Balance Sheets as of December 31, 2003 and 2002 Consolidated Statements of Income for the years ended December 31, 2003, 2002 and 2001 Consolidated Statements of Comprehensive Income for the years ended December 31, 2003, 2002 and 2001 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2003, 2002 and 2001 Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001 Notes to Consolidated Financial Statements (a) (2) Financial Statement Schedules Page Herein ----------------------------- ----------- The following financial statement schedules are being filed as part of this Form 10-K Report: Independent Auditors' Report on financial statement schedules for the years ended December 31, 2003, 2002 and 2001 55 Schedule I - Condensed Financial Information of Registrant 56-59 Schedule II - Valuation and Qualifying Accounts and Reserves 59 All other schedules are omitted as the required information is inapplicable or the information is presented in the financial statements or related notes. Separate financial statements of Midwest Wireless Holdings LLC, a 50 percent or less owned equity method investment, included as this entity constitutes a "significant subsidiary" pursuant to the provisions of Regulation S-X, Article 3-09. 60-78 (a) (3) Exhibits The exhibits which accompany or are incorporated by reference in this report, including all exhibits required to be filed with this report, are described on the Exhibit Index which appears on page 79 of the sequential numbering system used in this report. (b) REPORTS ON FORM 8-K FILED DURING THE THREE MONTHS ENDED DECEMBER 31, 2003 The Company furnished a Form 8-K on November 19, 2003 reporting under Item 7 and Item 12 a press release announcing its third quarter operating results. 53 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. HECTOR COMMUNICATIONS CORPORATION Dated: March 29, 2004 /s/ Curtis A. Sampson ---------------------------------------- Curtis A. Sampson, Chairman of the Board of Directors and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated: Signature Title Date ------------------------- ------------------------------------ -------------- /s/Curtis A. Sampson Chairman of the Board of Directors, March 29, 2004 ------------------------- Chief Executive Officer and Director Curtis A. Sampson /s/Steven H. Sjogren President, Chief Operating Officer, March 29, 2004 ------------------------- and Director Steven H. Sjogren /s/Paul N. Hanson Vice President, Treasurer and March 29, 2004 ------------------------- Director Paul N. Hanson /s/Charles A. Braun Chief Financial Officer and March 29, 2004 ------------------------- Principal Accounting Officer Charles A. Braun /s/Ronald J. Bach Director March 29, 2004 ------------------------- Ronald J. Bach /s/James O. Ericson Director March 29, 2004 ------------------------- James O. Ericson /s/Luella Gross Goldberg Director March 29, 2004 ------------------------- Luella Gross Goldberg /s/Paul A. Hoff Director March 29, 2004 ------------------------- Paul A. Hoff /s/Gerald D. Pint Director March 29, 2004 ------------------------- Gerald D. Pint /s/Wayne E. Sampson Director March 29, 2004 ------------------------- Wayne E. Sampson 54 HECTOR COMMUNICATIONS CORPORATION FINANCIAL STATEMENT SCHEDULES INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES Shareholders and Board of Directors Hector Communications Corporation The audit of the consolidated financial statements of Hector Communications Corporation and subsidiaries referred to in our opinion dated February 13, 2004, included the related financial statement schedules as listed in item 14(a) 2. In our opinion, these financial statement schedules, when considered in relation to the basic consolidated financial statements, present fairly in all material respects the information set forth therein. /s/ Olsen Thielen and Co., Ltd. ------------------------------- Olsen Thielen and Co., Ltd. St. Paul, Minnesota February 13, 2004 55 HECTOR COMMUNICATIONS CORPORATION SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY) BALANCE SHEETS December 31 ----------------------------- 2003 2002 ------------ ------------ Assets: Cash $ 293,225 $ 168,749 Investment in subsidiaries 68,115,882 44,381,330 Other current assets 1,412,500 217,996 Property, plant and equipment, net 761,108 613,875 Accounts with subsidiaries 3,418,743 167,731 Other investments 3,217,372 771,518 Other assets 159,238 ------------ ------------ Total Assets $ 77,378,068 $ 46,321,199 ============ ============ Liabilities and Stockholders' Equity: Accounts payable $ 305,738 $ 40,276 Other current liabilities 2,200,744 874,537 Current portion of long-term debt 3,306,000 223,000 Long-term debt 23,521,918 2,934,051 Stockholders' equity: Preferred stock, par value $1.00 per share; 3,000,000 shares authorized: Convertible Series A, 220,100 shares issued and outstanding 220,100 220,100 Common stock, par value $.01 per share; 10,000,000 shares authorized; 3,515,482 and 3,455,067 shares issued and outstanding 35,155 34,551 Additional paid-in capital 13,828,414 13,262,969 Retained earnings 33,908,774 28,742,832 Accumulated other comprehensive income (loss) 51,225 (11,117) ------------ ------------ Total Liabilities and Stockholders' Equity $ 77,378,068 $ 46,321,199 ============ ============ See notes to condensed financial statements of registrant. 56
HECTOR COMMUNICATIONS CORPORATION SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY) STATEMENT OF INCOME AND COMPREHENSIVE INCOME Year Ended December 31 ------------------------------------------------- 2003 2002 2001 ------------- ------------- ------------- Revenues: Sales $ 184,881 $ 175,232 $ 181,623 Expenses: Operating expenses 342,980 154,000 140,331 Amortization of goodwill 34,721 Interest expense, net 701,513 164,131 204,236 Income tax benefit (358,773) (44,775) (33,999) ------------- ------------- ------------- Total expenses 685,720 273,356 345,289 Loss before equity in earnings of subsidiaries (500,839) (98,124) (163,666) Equity in earnings of subsidiaries 5,679,599 606,444 4,779,820 ------------- ------------- ------------- Net income 5,178,760 508,320 4,616,154 Other comprehensive income (loss): Unrealized holding gains (losses) of subsidiaries on marketable securities 97,612 (304,758) 1,199,251 Reclassification adjustment for losses (gains) of subsidiaries included in net income 134,498 (3,659,055) ------------- ------------- ------------- Other comprehensive income (loss) before income taxes 97,612 (170,260) (2,459,804) ------------- ------------- ------------- Income tax expense (benefit) related to unrealized holding gains (losses) of subsidiaries on marketable securities 39,053 (125,492) 492,948 Income tax expense (benefit) related to reclassification adjustment for gains of subsidiaries included in net income 53,799 (1,504,043) ------------- ------------- ------------- Income tax expense (benefit) related to items of other comprehensive income 39,053 (71,693) (1,011,095) Minority interest in other comprehensive loss of subsidiaries (3,783) (16,138) (458,786) ------------- ------------- ------------- Other comprehensive income (loss) 62,342 (82,429) (989,923) ------------- ------------- ------------- Comprehensive income $ 5,241,102 $ 425,891 $ 3,626,231 ============= ============= ============= See notes to condensed financial statements of registrant.
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HECTOR COMMUNICATIONS CORPORATION SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT HECTOR COMMUNICATIONS CORPORATION (PARENT COMPANY) STATEMENTS OF CASH FLOWS Year Ended December 31 ------------------------------------------------- 2003 2002 2001 ------------- ------------- ------------- Cash flows from operating activities: Net income $ 5,178,760 $ 508,320 $ 4,616,154 Adjustments to reconcile net income to net cash provided by operating activities: Loss from other investments 7,094 2,692 448 Noncash patronage refund (12,368) (4,483) (8,326) Equity in earnings of subsidiaries (5,679,599) (606,444) (4,779,820) Depreciation and amortization 86,492 74,027 108,135 Changes in assets and liabilities: Other current assets (1,199,393) 344,919 16,721 Accounts with subsidiaries (3,251,012) 231,097 1,075,849 Accounts payable 265,462 (65,911) (82,693) Other current liabilities 1,465,357 163,000 190,440 ------------- ------------- ------------- Net cash provided by operating activities (3,139,207) 647,217 1,136,908 Cash flows from investing activities: Purchases of property, plant and equipment (225,118) (20,706) (82,243) Purchases of other investments (2,554,925) Cash proceeds from other investments 126,567 14,269 922 Increase in other assets (167,845) Investments in affiliates (17,999,944) ------------- ------------- ------------- Net cash used in investing activities (20,821,265) (6,437) (81,321) Cash flows from financing activities: Repayment of long-term debt (3,141,633) (208,583) (195,271) Proceeds from issuance of notes payable and long-term debt 26,812,500 Issuance of common stock 431,243 319,606 549,989 Purchase of stock (17,162) (737,455) (1,267,987) ------------- ------------- ------------- Net cash provided by (used in) financing activities 24,084,948 (626,432) (913,269) ------------- ------------- ------------- Net increase in cash and cash equivalents 124,476 14,348 142,318 Beginning cash and cash equivalents 168,749 154,401 12,083 ------------- ------------- ------------- Ending cash and cash equivalents $ 293,225 $ 168,749 $ 154,401 ============= ============= ============= Supplemental disclosures of cash flow information: Interest paid $ 524,940 $ 177,004 $ 342,242 Income taxes paid 1,446,590 371,000 285,000 See notes to condensed financial statements of registrant.
58 NOTES TO CONDENSED FINANCIAL STATEMENTS OF REGISTRANT Note 1 - Basis of Presentation Pursuant to the rules and regulations of the Securities and Exchange Commission, the Condensed Financial Statements of the Registrant do not include all of the information and notes normally included in financial statements prepared in accordance with generally accepted accounting principles. It is suggested that these Condensed Financial Statements be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Registrant's Annual Report as referenced in Form 10-K, Part II, Item 8. Note 2 - Investment in Subsidiaries In 2003 the Company acquired the 32% minority interest in Alliance Telecommunications Corporation. Note 3 - Long Term Debt
December 31 2003 2002 -------------------- ------------------ Note payable to CoBank in quarterly installments, interest Rate of 4.4%, due 2013 $ 26,125,000 Notes payable to former owners of Felton Telephone Company in monthly installments, interest rate of 8.25%, due 2005 702,918 Notes payable to Rural Telephone Finance Cooperative in quarterly installments, interest rate of 5.5%, due 2013 $ 3,365,634 Less current portion (3,306,000) (209,000) --------------------- ------------------- $ 23,521,918 $ 3,156,634 ===================== ==================
The annual requirements for principal payments on notes payable and long-term debt are as follows: 2004 $ 3,306,000 2005 2,896,000 2006 2,750,000 2007 2,750,000 2008 2,750,000 HECTOR COMMUNICATIONS CORPORATION AND SUBSIDIARIES Schedule II - Valuation and Qualifying Accounts and Reserves
Balance at Additions Deductions Balance Beginning of Charged to from Other at End Description Period Revenues Reserves Adjustments of Period --------- ----------- -------------- ----------- ----------- Allowance for doubtful accounts: Year ended: December 31, 2003 $ 716,000 $ 185,000 $ 78,000 (A) $ 285,000 (B) $ 538,000 December 31, 2002 $ 396,000 $ 1,017,000 $ 697,000 (A) $ 716,000 December 31, 2001 $ 360,000 $ 311,000 $ 275,000 (A) $ 396,000 (A) Accounts determined to be uncollectible and charged off against reserve. (B) Reserves from operations discontinued in Alliance split-up.
59 Midwest Wireless Holdings L.L.C. Consolidated Financial Statements December 31, 2003, 2002 and 2001 60 Midwest Wireless Holdings L.L.C. Index December 31, 2003 and 2002 ------------------------------------------------------------------------------- Page(s) Report of Independent Auditors...............................................62 Financial Statements Consolidated Statements of Financial Position................................63 Consolidated Statements of Operations........................................64 Consolidated Statements of Changes in Members' Equity........................65 Consolidated Statements of Cash Flows........................................66 Notes to Consolidated Financial Statements................................67-78 61 Report of Independent Auditors To the Board of Managers and Members of Midwest Wireless Holdings L.L.C. In our opinion, the accompanying consolidated statements of financial position and the related consolidated statements of operations, changes in members' equity, and cash flows present fairly, in all material respects, the consolidated financial position of Midwest Wireless Holdings L.L.C. (the "Company") and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations, changes in members' equity, and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 2 to the financial statements, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 143, Accounting for Asset Retirement Obligations, on January 1, 2003. As discussed in Note 3 to the financial statements, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, on January 1, 2002. PricewaterhouseCoopers LLP Minneapolis, Minnesota February 6, 2004 62
Midwest Wireless Holdings L.L.C. Consolidated Statements of Financial Position December 31, 2003 and 2002 ------------------------------------------------------------------------------------------------------------------ 2003 2002 Assets Current assets Cash and cash equivalents $ 1,888,366 $ 1,367,210 Accounts receivable, less allowance for doubtful accounts of $690,115 and $550,403 in 2003 and 2002, respectively 10,157,442 8,155,607 Inventories 2,579,643 1,411,573 Other current assets 1,301,616 1,511,589 ------------------- ------------------ Total current assets 15,927,067 12,445,979 Property, cellular plant and equipment, net 121,086,239 102,219,504 Intangible assets, net 230,141,013 194,612,163 Investments in cooperatives 9,104,667 9,006,847 ------------------- ------------------ Total assets $ 376,258,986 $ 318,284,493 =================== ================== Liabilities and Members' Equity Current liabilities Current portion of debt $ 16,361,168 $ 14,655,912 Revolving loan - 25,000,000 Accounts payable 6,136,971 5,643,416 Accrued commissions 1,941,673 1,436,325 Other accrued expenses 11,693,925 10,173,496 ------------------- ------------------ Total current liabilities 36,133,737 56,909,149 Other liabilities 3,381,894 988,120 Debt 169,480,481 114,458,723 ------------------- ------------------ Total liabilities 208,996,112 172,355,992 Minority interest 11,617,812 9,428,619 Commitments Members' equity 155,645,062 136,499,882 ------------------- ------------------ Total liabilities and members' equity $ 376,258,986 $ 318,284,493 =================== ================== The accompanying notes are an integral part of these consolidated financial statements.
63
Midwest Wireless Holdings L.L.C. Consolidated Statements of Operations Years Ended December 31, 2003, 2002 and 2001 ----------------------------------------------------------------------------------------------------------------- 2003 2002 2001 Operating revenues Subscriber service $ 140,823,140 $ 118,573,698 $ 93,477,223 Roamer service 28,107,407 37,205,402 36,953,474 Equipment sales 6,244,201 6,352,249 10,058,368 Service fees 4,389,092 565,834 49,450 ------------------- ------------------- ------------------ 179,563,840 162,697,183 140,538,515 ------------------- ------------------- ------------------ Operating expenses Operations and maintenance (exclusive of items shown separately below) 33,987,898 30,506,792 24,776,324 Cost of equipment sold 12,115,073 10,448,214 13,654,007 Home roamer costs 31,280,458 27,668,831 20,468,432 Depreciation 22,593,187 19,318,449 17,822,738 Amortization of intangible assets 267,278 - 4,505,851 Selling, general and administrative 41,111,864 35,113,593 31,292,529 ------------------- ------------------- ------------------ 141,355,758 123,055,879 112,519,881 ------------------- ------------------- ------------------ Operating income 38,208,082 39,641,304 28,018,634 ------------------- ------------------- ------------------ Other income (expense) Interest expense (7,204,744) (8,078,374) (9,416,290) Interest and dividend income 2,887 92,915 136,870 Other (61,529) 34,669 (41,784) ------------------- ------------------- ------------------ Total other expense (7,263,386) (7,950,790) (9,321,204) ------------------- ------------------- ------------------ Minority interest (3,494,303) (3,576,994) (2,109,070) ------------------- ------------------- ------------------ Income from continuing operations before cumulative effect of change in accounting principle 27,450,393 28,113,520 16,588,360 Cumulative effect of change in accounting principle net of minority interest (754,990) - - ------------------- ------------------- ------------------ Net income $ 26,695,403 $ 28,113,520 $ 16,588,360 =================== =================== ================== The accompanying notes are an integral part of these consolidated financial statements.
64
Midwest Wireless Holdings L.L.C. Consolidated Statements of Changes in Members' Equity Years Ended December 31, 2003, 2002 and 2001 ------------------------------------------------------------------------------------------------------------------ Total Capital Accumulated Members' Contributions Income Equity Balances at December 31, 2000 $ 84,797,020 $ 23,977,701 $ 108,774,721 Distributions to members - (8,174,899) (8,174,899) Net income - 16,588,360 16,588,360 ----------------- ------------------ ------------------ Balances at December 31, 2001 84,797,020 32,391,162 117,188,182 Redemption (83,921) (374,030) (457,951) Distributions to members - (8,343,869) (8,343,869) Net income - 28,113,520 28,113,520 ----------------- ------------------ ------------------ Balances at December 31, 2002 84,713,099 51,786,783 136,499,882 Issuance of units related to the acquisition of Iowa properties 1,941,468 - 1,941,468 Distributions to members - (9,491,691) (9,491,691) Net income - 26,695,403 26,695,403 ----------------- ------------------ ------------------ Balances at December 31, 2003 $ 86,654,567 $ 68,990,495 $ 155,645,062 ================= ================== ================== The accompanying notes are an integral part of these consolidated financial statements.
65
Midwest Wireless Holdings L.L.C. Consolidated Statements of Cash Flows Years Ended December 31, 2003, 2002 and 2001 ----------------------------------------------------------------------------------------------------------------- 2003 2002 2001 Cash flows from operating activities Net income $ 26,695,403 $ 28,113,520 $ 16,588,360 Adjustments to reconcile net income to net cash provided by operating activities Net income allocated to minority interest 3,398,600 3,576,994 2,109,070 Provision for bad debts 1,327,703 928,358 1,115,719 Depreciation 22,593,187 19,318,449 17,822,738 Amortization of intangibles 267,278 - 4,505,851 Gain on disposal of fixed assets (125,277) (3,645) (2,124) Writeoff of Cellular 2000, Inc. investment - 25,000 - Patronage received in form of cooperative stock (361,318) (310,848) (132,785) Cumulative effect of accounting change 850,693 - - Changes in assets and liabilities Accounts receivable (2,434,724) 1,851,263 (3,299,942) Inventories (1,168,070) 796,314 510,885 Other assets 234,808 (277,868) (546,637) Accounts payable 493,555 1,674,214 (2,156,106) Accrued expenses 179,454 863,987 1,888,444 Other liabilities 1,863,618 (425,552) (689,617) -------------- -------------- -------------- Net cash provided by operating activities 53,814,910 56,130,186 37,713,856 -------------- -------------- -------------- Cash flows from investing activities Acquisition of cellular properties (42,780,847) - - Payments for property, cellular plant and equipment (29,234,491) (31,901,881) (33,804,163) Proceeds from the disposal of fixed assets 518,573 - 37,571 Purchase of FCC licenses - (7,400,239) (22,400,000) Purchases of cooperative stock - (22,440) (1,176,440) Redemption of cooperative stock 421,527 72,970 68,313 Payments for deferred acquisition costs - - (192,511) -------------- -------------- -------------- Net cash used in investing activities (71,075,238) (39,251,590) (57,467,230) -------------- -------------- -------------- Cash flows from financing activities (Payments) proceeds on revolving loan (25,000,000) 5,000,000 17,500,000 Proceeds from debt borrowings 68,297,657 - 23,473,686 Payments on debt (14,815,075) (13,679,659) (11,016,802) Distributions to members (9,491,691) (8,343,869) (8,174,899) Distribution from subsidiary to minority interest (1,209,407) (1,062,371) (1,039,851) Redemption of units - (457,951) - -------------- -------------- -------------- Net cash provided by (used in) financing activities 17,781,484 (18,543,850) 20,742,134 -------------- -------------- -------------- Net change in cash and cash equivalents 521,156 (1,665,254) 988,760 Cash and cash equivalents Beginning of year 1,367,210 3,032,464 2,043,704 -------------- -------------- -------------- End of year $ 1,888,366 $ 1,367,210 $ 3,032,464 -------------- -------------- -------------- Supplemental disclosure Cash paid during the year for interest $ 8,165,844 $ 8,828,483 $ 10,540,203 Equity units issued for acquisitions 1,941,468 - - Noncash investing activities Equipment acquired under capital leases $ 3,244,433 - - The accompanying notes are an integral part of these consolidated financial statements.
66 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- 1. Business Description Midwest Wireless Holdings L.L.C. (the "Company") was formed in November 1999 as a Delaware limited liability company to acquire and operate cellular communications properties in the Midwest portion of the United States of America. Upon its formation, the Company exchanged its equity units for approximately 86% of the equity units of Midwest Wireless Communications, L.L.C. 2. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements include the Company's wholly owned subsidiaries, Midwest Wireless Iowa, L.L.C. and Midwest Wireless Wisconsin, L.L.C., as well as its majority owned subsidiary, Midwest Wireless Communications, L.L.C. All significant intercompany balances and transactions have been eliminated in consolidation. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the periods reported. Actual results could differ from those estimates. Concentration of Credit Risk The Company provides cellular service and cellular telephones to a diversified group of consumers within a concentrated geographical area. The Company performs credit evaluations of its customers and requires a deposit when deemed necessary. Receivables are generally due within 30 days. Cash and Cash Equivalents Cash and cash equivalents include cash on deposit and highly liquid investments with original maturities of three months or less. The Company has funds in excess of federally insured limits as of December 31, 2003 and 2002. Cellular Telephone Inventories Inventories consist primarily of cellular phones and accessories held for resale with cost determined using the specific identification method. Losses on sales of cellular phones are recognized in the period in which sales are made as a cost of acquiring subscribers. 67 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Property, Cellular Plant and Equipment Property, cellular plant and equipment is stated at its original cost. Depreciation is provided on a straight-line basis over the estimated useful lives of the cellular plant and equipment. The estimated useful lives of the cellular plant and equipment are as follows: Buildings and improvements 3-30 years Other equipment 2-20 years Communications and network equipment 7-15 years Vehicles 3 years Computer equipment 3 years Major renewals or betterments are capitalized, while repair and maintenance expenditures are charged to operations as incurred. Interest incurred on external borrowings during construction is capitalized. The cost and accumulated depreciation of property, cellular plant and equipment disposed of or sold are eliminated from their respective accounts, and the resulting gain or loss is recorded in operations. Intangible Assets Customer relationships are amortized on a straight-line basis over two to six years. FCC licenses consist of the cost of acquiring cellular, personal communication services ("PCS"), and local multi-point distribution licenses. It also includes the value assigned to cellular licenses acquired through the acquisitions of operating cellular systems. The Company ceased amortization of its licenses effective January 1, 2002, with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets (Note 3). Long-Lived Assets The Company periodically reviews long-lived assets and fixed assets for impairment whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Recoverability is based on projected cash flows on an undiscounted basis. On January 1, 2003, the Company adopted SFAS No. 143, Accounting for Asset Retirement Obligations. This statement relates to the costs of closing facilities and removing assets. SFAS No. 143 requires entities to record the fair value of a legal liability for an asset retirement obligation ("ARO") in the period it is incurred if a reasonable estimate of fair value can be made. This cost is initially capitalized and amortized over the remaining life of the underlying assets. Once the obligation is ultimately settled, any difference between the final cost and the recorded liability is recognized as a gain or loss. For the Company, an ARO includes those costs associated with removing component equipment that is subject to retirement from cell sites that reside upon leased property. As a result of adopting SFAS No. 143, on January 1, 2003, the Company recorded an ARO of $1,266,744 and a cumulative effect of this reduction in net income, reflecting the change in accounting principle of $850,693. The cumulative effect of this change resulted from accumulated accretion and depreciation of the ARO and related asset as of January 1, 2003 through December 31, 2002. After a minority interest effect of $95,703, the net charge was $754,990. Accretion and depreciation expenses for the year 2003 related to the ARO were $186,161. 68 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Revenue Recognition Service revenue consists of the base monthly service fee and airtime revenue. Base monthly service fees are billed one month in advance and are recognized in the month earned. Airtime and roamer revenue is recognized when the service is provided. The Company recognizes revenue for equipment installation when the installation is completed and the Company recognizes equipment revenue when the equipment is delivered and accepted by customers. Roaming Revenue Reclassification The Company generates revenue from charges to its customers when they use their cellular phones in other wireless providers' markets ("Incollect Revenue"). Until 2002, the Company included Incollect Revenue on a net basis as a component of Home Roamer Costs as an operating expense in its statement of operations. Expense associated with Incollect Revenue, charged by third-party wireless providers, is also included in Home Roamer Costs. The Company used this method because, historically, it had passed through to its customers most of the costs related to Incollect Revenue. However, the wireless industry and the Company have increasingly been using pricing plans that include flat rate pricing and larger home service areas. Under these types of plans, amounts charged to the Company by other wireless providers may not necessarily be passed through to its customers. In 2002, the Company adopted a policy to include Incollect Revenue as Subscriber Service revenue rather than in Home Roamer Costs on a net basis. Roamer Service Revenue includes only the revenue from other wireless providers' customers who use the Company's network ("Outcollect Revenue"). Subscriber Service Revenue and Home Roamer Costs in the 2001 and 2000 consolidated financial statements were reclassified to conform to this presentation. This change in presentation has no impact on operating income, net income or members' equity. The Company recorded Incollect Revenue of $9,021,044, $8,434,482 and $7,549,289 for the years ended December 31, 2003, 2002 and 2001, respectively. Income Taxes No provision for income taxes has been recorded since all income, losses and tax credits are allocated to the members for inclusion in their respective income tax returns. Advertising Advertising costs are expensed as incurred. Total advertising expenses were $3,310,758, $3,317,280 and $4,448,949 for the years ended December 31, 2003, 2002 and 2001, respectively. Stock-Based Compensation The Company accounts for stock-based compensation using the intrinsic value method. Accordingly, compensation cost for stock options granted to employees is measured as the excess, if any, of the fair value of the stock at the date of the grant over the amount an employee must pay to acquire the stock. Such compensation costs are amortized on a straight-line basis over the underlying option's vesting term. No such compensation expense was recognized for the years ended December 31, 2003, 2002 and 2001. 69 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- If the Company had elected to recognize compensation expense for options granted using the fair value method, net income would have been as follows: 2003 2002 2001 Net income, as reported $ 26,695,403 $ 28,113,520 $ 16,588,360 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (199,789) (337,615) (214,783) ------------ ------------ ------------ Pro forma net income $ 26,495,614 $ 27,775,905 $ 16,373,577 ============ ============ ============ 3. Goodwill, FCC Licenses and Other Intangible Assets Effective January 1, 2002, the Company adopted SFAS No. 142. Effective with the adoption of this standard, the Company no longer amortizes FCC licenses ("licenses"), which consist of licenses that provide the Company with the exclusive right to utilize certain radio frequency spectrum to provide wireless communication services. Although the licenses are issued for only a fixed time, generally ten years, they are subject to renewal by the FCC; but the renewals of licenses have occurred routinely and at nominal cost. Moreover, there are currently no legal, regulatory, contractual, competitive, economic, or other factors that limit the useful lives of the licenses. As a result, licenses are treated as indefinite-lived intangible assets and will not be amortized but rather are tested annually for impairment. The Company evaluates the useful life determination for licenses each reporting period to determine whether events and circumstances continue to support an indefinite life. In connection with the adoption of SFAS No. 142, the Company completed a transitional and impairment test for its licenses and determined that there was no impairment. The Company also completed annual impairment tests on December 31, 2003 and 2002, and determined that there was no impairment. The Company utilized a fair value approach, primarily using discounted cash flows, to complete the impairment tests. On October 15, 2003, the Company acquired various cellular communications properties (Note 5). The Company allocated a portion of the excess purchase price over the fair value of the net tangible assets acquired to goodwill. The Company does not amortize goodwill, but will complete annual impairment tests of the goodwill to determine if impairment exists. As a result of this acquisition, $9,426,669 of goodwill was recorded with no accumulated amortization. On a prospective basis, the Company is required to test both goodwill and indefinite-lived intangible assets for impairment on an annual basis based upon a fair value approach. Additionally, goodwill will be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of entity below its carrying value. These events or circumstances would include a significant change in the business climate, including a significant sustained decline in an entity's market value, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business, or other factors. Other indefinite-lived intangible assets will be tested between annual tests if events or changes in circumstances indicate that the asset might be impaired. The Company will next perform its annual impairment test for both goodwill and licenses during the fourth quarter of 2004. 70 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Indefinite-lived intangible assets consist of the following at December 31: 2003 2002 FCC Licenses $ 222,015,830 $ 204,534,427 Less: Accumulated amortization (9,922,264) (9,922,264) ------------- ------------- $ 212,093,566 $ 194,612,163 ============= ============= The changes in the carrying amount of goodwill and FCC licenses for the year ended December 31, 2003, are as follows: Goodwill FCC Licenses Balance as of January 1, 2003 $ - $ 194,612,163 Goodwill or FCC licenses acquired or finally allocated during the year 9,426,669 17,481,403 ------------- ------------- Balance as of December 31, 2003 $ 9,426,669 $ 212,093,566 ============= ============= The adjusted amounts shown below reflect the effect of retroactive application of discontinuance of the amortization of licenses as if the new method of accounting had been in effect during 2001. 2003 2002 2001 Net income Reported net income $ 26,695,403 $ 28,113,520 $ 16,588,360 Amortization - - 4,505,851 ------------ ------------ ------------- Adjusted net income $ 26,695,403 $ 28,113,520 $ 21,094,211 ============ ============ ============= Definite-lived intangible assets consist of the following at December 31: 2003 2002 Customer relationships $ 8,888,056 $ - Less: Accumulated amortization (267,278) - -------------- ------------- $ 8,620,778 $ - ============== ============= Amortization expense related to definite-lived intangible assets was $267,278 in 2003. 71 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Estimated amortization expense of identified intangible assets for the next five years is as follows: 2004 $ 1,551,518 2005 1,510,927 2006 1,450,000 2007 1,450,000 2008 1,450,000 4. Select Account Information Property, Cellular Plant and Equipment 2003 2002 Land $ 5,736,838 $ 3,643,696 Plant in service 189,462,369 153,533,992 Plant under construction 10,378,016 6,815,296 ------------- ------------- 205,577,223 163,992,984 Less: Accumulated amortization (84,490,984) (61,773,480) ------------- ------------- $ 121,086,239 $ 102,219,504 ============= ============= The Company capitalized interest in the amount of $385,157, $443,911 and $581,879 for the years ended December 31, 2003, 2002 and 2001, respectively. At December 31, 2003 and 2002, accounts payable included $612,404 and 2,100,831, respectively, related to the purchase of property, cellular, plant and equipment. Property, cellular plant and equipment includes plant in service under lease with a cost basis of $3,244,433 and accumulated depreciation of $118,251. 5. Acquisitions On October 15, 2003, the Company, through its wholly owned subsidiary, Midwest Wireless Iowa, L.L.C., completed an acquisition of cellular communications properties providing services to a 17-county area of Iowa. The acquisition was accounted for as a purchase. Accordingly, the Company allocated the excess purchase price over the fair value of the net tangible assets acquired to FCC licenses, Goodwill and Customer Relationships. The fair value of the acquired intangible assets was based on an independent appraisal of the FCC licenses and Customer Relationships. The Company is amortizing the value of Customer Relationships over six years. As a result, the financial statements include the operations related to the acquisition beginning at the acquisition date. 72 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- The following table presents the computation of the purchase price, the estimated fair value of tangible assets, FCC Licenses, Customer Relationships acquired, and the amount allocated to goodwill. Amounts were allocated to tangible assets and liabilities based upon their fair values as of the date of acquisition. The fair value of property, cellular plant and equipment was based upon an independent appraisal. Cash $ 41,018,532 Equity units issued 1,941,468 Acquisition costs 1,092,858 Liabilities assumed and resulting from acquisition Accounts payable and accrued liabilities 19,250 Customer deposits 64,450 Deferred revenue 425,393 Allowance for customer conversion 1,337,230 ------------- Total purchase price 45,899,181 ------------- Estimated fair value of tangible assets acquired Accounts receivable 816,334 Prepaid expenses and unbilled revenue 103,315 Investment in cooperatives 158,029 Property, cellular plant and equipment 9,694,834 ------------- Total tangible assets 10,772,512 ------------- Estimated fair value of intangible assets acquired Customer relationships 8,700,000 FCC licenses 17,000,000 ------------- Total intangible assets 25,700,000 ------------- Net assets acquired 36,472,512 ------------- Goodwill $ 9,426,669 ============= On June 25, 2001, the Company acquired eight digital PCS licenses from McLeod USA, Inc. for a total purchase price of $22,400,000. The purchase is for spectrum licenses only and does not include any other assets. The licenses cover a total population of approximately 1.4 million in 63 counties in northern Iowa, southern Minnesota, eastern South Dakota, eastern Nebraska and western Illinois. The purchase price together with costs incurred of approximately $100,000 to complete the transaction was allocated to FCC licenses. In July 2002, the Company acquired three digital PCS licenses for $7,385,058. The agreement is for the purchase of spectrum licenses only and does not include any other assets. The licenses cover 26 counties primarily in southern Minnesota. 6. Members' Capital Members' capital includes capital contributions made by the members and the accumulated income resulting from operations. Company income or loss is allocated to the individual members based upon their ownership percentage, as defined in the Limited Liability Company Agreement (the "Agreement"). Pursuant to the Agreement, members are not obligated for the debts and obligations of the Company, including accumulated losses in excess of capital contributions. 73 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Under the Agreement certain restrictions exist that dictate the specific terms of any transfer or sale of units. Upon receipt of a bona fide offer in writing from a third party, the other members and then the Company have the right to purchase all, but not less than all, of the units at the bona fide offer price within a specified time frame. The Agreement also contains the right of co-sale under which no member may transfer its units to an acquiring person, as defined in the Agreement, who after such transfer would be an acquiring person without assuring that each of the other members may participate in the transfer of units under the same terms and conditions. The right of co-sale would terminate in the event the Company completes a sale of securities pursuant to a securities act or if the Company's market capitalization would exceed $200,000,000. Each member is entitled to one vote for each unit owned. Certain restrictions on voting rights exist when units are sold to an acquiring person. 7. Debt Debt consists of the following:
Rate at Balance at December 31 December 31 --------------------- ------------------------------------ Maturity 2003 2002 2003 2002 RTFC note, variable rate 5/12/09 4.40% 5.50% $ 8,469,711 $ 9,735,315 RTFC note, variable rate 4/30/09 4.40% 5.50% 17,726,490 20,375,286 RTFC note, variable rate 7/29/08 4.40% 5.75% 5,012,518 5,882,114 RTFC note, variable rate 7/28/08 4.40% 5.50% 4,585,861 5,381,438 RTFC note, variable rate 3/2/10 4.40% 5.50% 71,511,346 80,191,775 RTFC note, variable rate 2/3/15 4.40% 5.50% 7,152,796 7,548,707 CoBank note, variable rate 10/20/03 5.00% - 25,000,000 CoBank note, variable rate 6/30/09 4.75% 55,000,000 - CoBank note, variable rate 6/30/09 4.75% 13,297,657 - Farm Credit Leasing 10/16/06 3.82% 1,969,350 - Farm Credit Leasing 11/30/08 4.00% 1,115,920 - -------------- -------------- $ 185,841,649 $ 154,114,635 Less: Current maturities (16,361,168) (39,655,912) -------------- -------------- $ 169,480,481 $ 114,458,723 ============== ==============
The Company has entered into various agreements (the "Agreements") with the Rural Telephone Finance Cooperative ("RTFC"). In 2000, the Company entered into an agreement to fund the acquisitions of the Iowa and Wisconsin cellular markets and the construction of a new headquarters building. The Agreements provide for borrowings of up to $159,725,739. The principal and interest on the variable and fixed rate notes are payable in quarterly installments. The Agreements provide the Company the option to fix the interest rate on borrowings (or portions thereof) through the maturity date. The variable rate is based on RTFC's cost of capital and is adjusted monthly. The Agreements also provide for a revolving loan of up to $10,000,000. Borrowings under the revolving loan bear interest at the prime rate plus 1.5%. The outstanding principal and interest are due upon maturity. At December 31, 2003 and 2002, the Company had no borrowings outstanding under the RTFC revolving loan. 74 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- The Agreements require the Company to maintain an investment in RTFC in the amount of at least 5% of the outstanding debt balance. The Agreements also contain covenants that restrict distributions to members and require the Company to maintain a current ratio of not less than 1.25. At December 31, 2002 and 2003, the Company was not in compliance with this covenant, but a waiver was provided by RTFC. Substantially all assets of the Company are pledged as collateral under the Agreement. On October 22, 2001, the Company entered into an agreement with CoBank, ACB ("CoBank") to fund the acquisition of various PCS licenses, capital expenditures and operating funds. The original agreement provided for borrowings of up to $40,000,000 (the "revolving loan"). At December 31, 2001, the Company had drawn $20,000,000 on the revolving loan. At December 31, 2001, borrowings under the agreement bore interest at LIBOR plus 2.5% or 4.85%. On November 22, 2002, the Company amended the agreement to provide for borrowings of up to $65,000,000, amended the interest rate pricing, and extended the expiration date to October 20, 2003. At December 31, 2002, the Company had drawn $25,000,000 on the revolving loan. At December 31, 2002, borrowings under the agreement bore interest at LIBOR plus 3.5% or 5.0%. On October 15, 2003, the Company amended the agreement to provide for borrowings up to $80,000,000 including a single draw term loan of $55,000,000 with interest at LIBOR plus 3.5% or prime plus 2.5%, a $20,000,000 revolving loan ("Revolver B") with interest at LIBOR plus 3.5% or prime plus 2.5%, and a $5,000,000 secured cash management revolving loan ("Revolver A") with interest at prime plus 0.75%. The total facility matures on June 30, 2009. The term facility has scheduled principal payments beginning the first quarter of 2005, Revolver B has mandatory commitment reductions beginning in the first quarter of 2007. The CoBank loan is subject to various covenants including a limit on the ratio of indebtedness to annualized operating cash flow, a minimum ratio of operating cash flow to interest paid, and a minimum debt coverage service ratio. Substantially all the assets of the Company are pledged as collateral under the agreement with CoBank. RTFC and CoBank have agreed to share a security interest in the Company's assets on a pro rata basis. On October 10, 2003, the Company entered into a lease agreement with Farm Credit Leasing. It entered into a lease under the agreement on October 15, 2003, for the lease of a switch and related equipment located in Des Moines, Iowa. The cost of the equipment leased was $2,000,000. The lease provides for monthly payments of $48,385 for 36 months. The Company has the option to acquire the equipment at the end of the lease for $400,000 or renew the lease for an additional 12 months. On December 24, 2003, the Company entered into a second lease under the agreement for the lease of network equipment. The cost of the equipment was $1,040,177. The lease provides for monthly payments of $15,963 for 60 months. The Company has the option to acquire the equipment at the end of the lease for $208,035 or renew the lease for an additional 12 months. Both of these leases have been recorded as capital leases and therefore the assets subject to the lease have been capitalized and the lease obligation has been recorded as debt. 75 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Maturities of debt are as follows: 2004 $ 16,361,168 2005 22,566,421 2006 26,521,849 2007 34,353,076 2008 43,385,638 Thereafter 42,653,497 ---------------- $ 185,841,649 ================ 8. Operating Lease Commitments Future minimum rental payments required under operating leases, principally for real estate related to tower sites, and other contractual commitments that have initial or remaining noncancellable terms in excess of one year at December 31, 2003, are as follows: 2004 $ 1,366,937 2005 1,154,048 2006 920,650 2007 648,342 2008 335,151 Thereafter 814,999 ---------------- $ 5,240,127 ================ Rental expense was $2,079,076, $1,645,524 and $955,514 for the years ended December 31, 2003, 2002 and 2001, respectively. 9. Employee Benefits The Company established the Midwest Wireless Holdings L.L.C. and Subsidiary Companies 401(k) Profit Sharing Plan and Trust (formerly the Midwest Wireless Communications L.L.C. Profit Sharing Plan and Trust) (the "401(k) Plan") for all employees who meet certain service and age requirements. The 401(k) Plan is comprised of an employer matching contribution component and a profit sharing component. Employer matching contributions to this component of the plan were $493,124, $473,644 and $376,783 for the years ended December 31, 2003, 2002 and 2001, respectively. Profit sharing contribution expenses were $597,716, $544,981 and $455,778 for the years ended December 31, 2003, 2002 and 2001, respectively. Profit sharing contributions are 100% vested after five years of employment. 76 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- Effective January 1, 1997, the Company established the Midwest Wireless Holdings L.L.C. Appreciation Rights Plan, as amended (formerly the Midwest Wireless Communications L.L.C. Appreciation Rights Plan) (the "Plan") for certain key employees. The Plan is designed to create two classes of appreciation rights, Class A and Class B, which become fully vested three years and five years, respectively, after the first day of the year the rights are granted. Participants in the Plan are eligible to receive awards based on defined increases in members' equity from the date of grant through the end of the vesting period. The Board of Managers granted both Class A and Class B appreciation rights in 1997. Under the terms of the Plan, no additional Class B appreciation rights will be granted, and additional Class A appreciation rights will be granted at the discretion of the Board of Managers. However, effective January 1, 2002, the Plan was amended to enable additional Class B appreciation rights to be granted in 2002. In 2000 and 2001, the Board of Managers issued additional Class A appreciation rights to certain key employees and in 2000 authorized an additional 9,000 rights for new Plan participants. The Company recognized $1,359,360, $1,287,172 and $1,053,863 in compensation expense related to the Plan for the years ended December 31, 2003, 2002 and 2001, respectively. 10. Option Plan During 2000, the Company's Board of Managers adopted and approved the Midwest Wireless Holdings L.L.C. Unit Option Plan, as amended. Effective July 2001, the Plan was amended to clarify certain language and definitions in the Plan. Under the Plan, options to purchase 46,742 of the Company's membership units may be granted to employees with terms and vesting periods determined by the Company's Board of Managers at the date of grant. The exercise price is equal to the fair value of the units at the time the option is granted, as determined by the Board of Managers. Options granted under the plan expire ten years from the date of grant. The options granted vest 100% three years after they are granted. At December 31, 2003, there were 30,343 units available for issuance under this plan. Options Outstanding ---------------------- Weighted Available Average for Number Price Per Grant of Units Unit Balances at December 31, 2001 37,940 8,802 $309.37 Granted (4,809) 4,809 $344.00 ------- ------- Balances at December 31, 2002 33,131 13,611 $321.60 Granted (2,788) 2,788 $263.84 ------- ------- Balances at December 31, 2003 30,343 16,399 $311.78 ======= ======= The weighted average fair value of options at the date of grant was $58.03, $66.12 and $52.73 in 2003, 2002 and 2001, respectively. 77 Midwest Wireless Holdings L.L.C. Notes to Consolidated Financial Statements December 31, 2003 -------------------------------------------------------------------------------- The following table summarizes information about stock options outstanding and exercisable at December 31, 2003: Options Outstanding Options Exercisable ----------------------------- ------------------- Weighted Average Weighted Weighted Remaining Average Average Contractual Exercise Exercise Exercise Prices Number Life Price Number Price $263.84 2,788 9.01 $263.84 - - $299.06 4,092 6.59 $299.06 4,092 $299.06 $318.32 4,285 7.01 $318.32 4,285 $318.32 $318.32 425 7.65 $318.32 425 $318.32 $344.00 4,809 8.01 $344.00 - - The fair value for each option grant was estimated at the date of grant using the minimum value method with the following assumptions: Fiscal Year ------------------------------------ 2003 2002 2001 Dividend yield 3.46% 2.33% 2.47% Risk-free interest rate 4.07% 5.20% 4.73% Expected lives 10 years 10 years 10 years 78 HECTOR COMMUNICATIONS CORPORATION EXHIBITS Exhibit Index To Form 10-K for the Year Ended December 31, 2003 Regulation S-K Location in Consecutive Numbering Exhibit Table System as Filed With the Reference Title of Document Securities and Exchange Commission ------------------------------------------------------------------------------- 3.1 Articles of Incorporation, Filed as Exhibit 3.1 to the Form 10 as amended of the Company, File No. 0-18587 (the "Form 10") and incorporated hereby by reference 3.2 Bylaws, as amended Filed as Exhibit 3.2 to the Form 10 of the Company and incorporated hereby by reference. 10.1 1990 Stock Plan Filed as Exhibit 10.1 to the Form 10 of the Company and incorporated herein by reference. 10.2 2003 Employee Stock Purchase Filed as Exhibit 4.2 to Form S-8 of Plan the Company dated Februart 24, 2004 and incorporated herein by reference. 10.3 Employee Stock Ownership Plan Filed as Exhibit 10.3 to the Form 10 of the Company and incorporated herein by reference. 10.4 Employee Savings Plan and Trust Filed as Exhibit 10.4 to the Form 10 of the Company and incorporated herein by reference. 10.5 Distribution Agreement Filed as Exhibit 10.5 to the Form 10 of the Company and incorporated herein by reference. 10.7 Flexible Benefit Plan Filed as Exhibit 10.7 to the 1993 Form 10-K and incorporated herein by reference. 10.8 Form of Rights Agreement dated Filed as Exhibit 1 to the Company's as of July 27, 1999 between the Form 8-A on August 9, 1999 and Company and Norwest Bank, incorporated herein by reference. Minnesota, National Association 10.9 1999 Stock Plan Filed by the Company on Form S-8 on December 3, 1999 and incorporated herein by reference. 11 Calculation of Earnings Filed herewith. Per Share 21 Subsidiaries of the Registrant Filed herewith. 23 Independent Auditors' Consent Filed herewith. 24 Power of Attorney Filed herewith. 31.a Certification of the Chief Filed herewith. Executive Officer pursuant to Section 302 of the Sarbanes- Oxley Act of 2002 31.b Certification of the Chief Filed herewith. Financial Officer pursuant to Section 302 of the Sarbanes- Oxley Act of 2002 99.1 Certification under 18 U.S.C. Filed herewith. ss. 1350 The exhibits referred to in this Exhibit Index will be supplied to a shareholder at a charge of $.25 per page upon written request directed to HCC's Assistant Secretary at the executive offices of the Company. 79