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SUREWEST COMMUNICATIONS - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) (Amounts in thousands, except select operating metrics and share and per share amounts) Certain statements included in this report, including that which relates to the impact on future revenue sources and potential sharing obligations of pending and future regulatory orders, continued expansion of the telecommunications network and expected changes in the sources of our revenue and cost structure resulting from our entrance into new communications markets, are forward-looking statements and are made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. These forward looking statements generally are identified by the words "believe", "expect", "anticipate", "estimate", "intend", "should", "may", "will", "would", "will be", "will continue" or similar expressions. Such forward looking statements involve known and unknown risks, the impact of current economic conditions, uncertainties and other factors that may cause actual results, performance or achievements of SureWest Communications (the "Company", "we" or "our") to be different from those expressed or implied in the forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in our 2010 Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC"). We disclaim any intention or obligation to update or revise publicly any forward-looking statements. Management's Discussion and Analysis ("MD&A") should be read in conjunction with our unaudited condensed consolidated financial statements and accompanying notes to the financial statements ("Notes") as of and for the six months ended June 30, 2011 included in Item 1 of this Quarterly Report on Form 10-Q. Throughout MD&A, we refer to measures that are not a measure of financial performance in accordance with United States generally accepted accounting principles ("US GAAP" or "GAAP"). We believe the use of these non-GAAP measures on a consolidated and segment basis provides the reader with additional information that is useful in understanding our operating results and trends. These measures should be viewed in addition to, rather than as a substitute for, those measures prepared in accordance with GAAP. See the Non-GAAP Measures section below for a more detailed discussion on the use and calculation of these measures. Overview We are one of the leading providers of integrated communications services and are the bandwidth leader in the markets we serve. We provide data, video and voice services to residential and business customers in the greater Sacramento, California ("Sacramento region") and greater Kansas City, Kansas and Missouri areas ("Kansas City area"). We continue to expand the use of optical fiber in our networks. We increasingly deploy our services by combining fiber-to-the-home ("FTTH") and fiber-to-the-node ("FTTN") facilities with the use of Internet Protocol ("IP") based communications protocol. Our advanced telecommunications networks give us a competitive edge that enables us to provide our customers with higher data speeds for Internet service and deploy multiple services at superior quality through our high bandwidth capacity. Our IP based communication protocol enables us to provide dedicated bandwidth at symmetrical data speeds to each of our customers in the Sacramento region. We classify our operations in two reportable segments: Broadband and Telecommunications ("Telecom"). Broadband Segment During the six-month period ended June 30, 2011, our Broadband segment generated approximately 75% of our consolidated operating revenues, primarily from subscriptions to our data, video and voice services ("broadband services"). We market our broadband services to residential and business customers, either individually or as part of a bundled package. As of June 30, 2011, our broadband services served approximately 105,100 residential subscribers, of which 82% subscribed to two or more of our broadband services, including 47% that subscribed to all three of our broadband services ("triple play"). As of June 30, 2011, we had approximately 7,900 business customers. New products and features including Advanced Digital TV ("ADTV"), faster data speeds, increased high definition ("HD") channels, home networking and Internet security software created enhanced subscriber value for our broadband services. We continue to successfully offset industry-wide declines of operating revenues in the Telecom segment with our long-term strategy to grow our Broadband operations. Our data service can provide high-speed Internet access at symmetrical speeds of up to 50 megabits per second ("Mbps"), depending on the nature of the network facilities that are available, the level of service selected and the geographic market availability. Our advanced telecommunications networks gives us the ability to offer our customers in many locations both faster and symmetrical data speeds, meaning Internet speeds downstream are the 16 -------------------------------------------------------------------------------- Table of Contents same as those upstream, than those of our competitors. Customers can use the faster speeds for such things as enhanced online gaming and faster uploading and downloading of multimedia content such as music, photos and video. As of June 30, 2011, approximately 59% and 29% of our data customers subscribed to speeds of 5 Mbps and 15 Mbps or greater, respectively. In the Sacramento region, approximately 40% of our data customers subscribe to plans with speeds at or higher than 15 Mbps. As of June 30, 2011, approximately 32% of the homes in the areas we serve subscribed to one of our high-speed Internet services. Our video services range from a limited basic service to our new product offering ADTV, powered by Microsoft® Mediaroom™. Depending on the service selected and subject to geographic market availability, our video service subscribers have access to over 310 channels, including premium and pay-per-view channels (which include concerts, sporting events and movies); video on demand ("VOD") service (which allows access to a library of movies and the ability to start a selection at any time and to pause, rewind, fast-forward and replay); premium VOD channels, music channels and an interactive, on-screen program guide (which allows the subscriber to navigate the channel lineup, the VOD library and recorded programs). Digital video subscribers may also subscribe to our advanced services, which consist of high-definition television ("HDTV"), and/or digital video recorders ("DVR"). Our ADTV product, which is currently available in the Sacramento region only, includes a Whole Home DVR, which allows customers the ability to watch recorded shows on any television in the house, record multiple shows at one time and utilize an intuitive on-screen guide and user interface. We anticipate the deployment of a Whole Home DVR in the Kansas City area during the latter half of 2011. As of June 30, 2011, approximately 23% of the homes in the areas we serve subscribed to one of our video services. Our Voice over Internet Protocol ("VoIP") digital phone product is available in the Sacramento market, including those customers residing in the Telecom segment service territory. Customers can select individual services or bundled packages that may include unlimited local calling or unlimited local and domestic long distance calling plans. Our voice products also include value-added services such as voicemail, call waiting, caller identification and many other calling feature options. As of June 30, 2011, approximately 19% of the homes in our Sacramento market have subscribed to our VoIP phone service. We also offer traditional circuit-switched voice services in the areas we serve. The total voice penetration in the markets we serve was approximately 24% as of June 30, 2011. We provide a variety of business communications services to small, medium and large business customers. The services we offer to our business customers include: fiber-optics-based high-speed Internet, customized data and Ethernet transport services, data center and disaster recovery solutions, traditional landline and VoIP phone services, wireless backhaul and digital TV. Utilizing our existing fiber-optic network, we have successfully secured contracts to serve approximately 390 wireless backhaul access points, primarily in the Sacramento region. We anticipate backhaul revenue will continue to grow as wireless carriers, faced with escalating consumer and business demand for mobile broadband connectivity, are forced to expand and improve their networks, and to replace existing backhaul facilities with new facilities capable of handling more traffic faster. Telecom Segment Our Telecom segment, which operates only in the Sacramento region, offers a broad selection of telecommunications services including traditional circuit-switched voice services, long distance services and a number of lightly-regulated or non-regulated services. Most long distance services are offered by our subsidiary SureWest Long Distance, which is a reseller of long distance services. The Telecom segment provides a variety of business service offerings to small, medium and large business customers, including many services over our advanced fiber network. The services we offer to our business customers include, but are not limited to high-speed Internet, customized data and Ethernet transport services, data center and disaster recovery solutions, traditional landline and scalable IP communication systems. Although we have experienced declines in the Telecom segments business customer counts in recent years, we anticipate the Telecom segment's business customer count will stabilize and begin to trend favorably. The Telecom segment also provides wholesale access services through the use of its network to the Broadband segment, which enables the Broadband segment to offer high-speed Internet, VoIP and video services to some customers within SureWest Telephone's service area. We anticipate the wholesale access services revenue stream will continue to increase as customers within the Telecom segment service territory continue to demand more broadband services. Telecom segment revenues have decreased as a percentage of our consolidated revenues over the past several years. During the six months ended June 30, 2011, the Telecom segment generated 25% of our consolidated revenues, a 17 -------------------------------------------------------------------------------- Table of Contents decrease of 4% compared to the same period in 2010. The decline in revenues is primarily the result of an industry wide trend of declining circuit-switched voice Revenue-generating units ("RGUs") and a corresponding reduction in the use of related services. Many customers are choosing to subscribe to our Broadband Digital Phone product instead of the traditional circuit-switched phone service offered by SureWest Telephone. In addition, the Telecom segment revenues have been impacted by scheduled reductions in the subsidies we receive from governmental regulatory agencies. We expect the declines in Telecom revenues to flatten over the next two years, as the scheduled phase out of certain Telecom support mechanisms is completed and access line losses ease. The Telecom segment continues to generate the majority of our net income and free cash flow and remains an important part of our long-term growth strategy to fund the expansion of our Broadband segment. Results of Operations The tables below reflect certain financial data (on a consolidated and segment basis) and select operating metrics for each of our reportable segments as of and for the quarters and six-month periods ended June 30, 2011 and 2010. Financial Data Quarter Ended June 30, Six Months Ended June 30, $ % $ % 2011 2010 Change Change 2011 2010 Change Change Operating revenues (1) Broadband $ 45,959 $ 43,076 $ 2,883 7 % $ 91,338 $ 85,653 $ 5,685 7 % Telecom 15,003 17,472 (2,469) (14) 30,179 35,083 (4,904) (14) Operating revenues 60,962 60,548 414 1 121,517 120,736 781 1 Income (loss) from operations Broadband (2,608) (4,922) 2,314 47 (6,094) (9,494) 3,400 36 Telecom 6,904 6,959 (55) (1) 12,378 14,673 (2,295) (16) Income from operations 4,296 2,037 2,259 111 6,284 5,179 1,105 21 Net income (loss) Broadband (3,006) (4,269) 1,263 30 (7,411) (7,989) 578 7 Telecom 4,326 3,742 584 16 7,087 7,989 (902) (11) Net income (loss) 1,320 (527) 1,847 350 (324) - (324) (100) Net cash provided by operating activities 20,562 10,086 10,476 104 39,934 26,427 13,507 51 Adjusted EBITDA (2) Broadband 11,397 8,409 2,988 36 21,730 16,608 5,122 31 Telecom 10,832 11,519 (687) (6) 20,220 22,788 (2,568) (11) Adjusted EBITDA 22,229 19,928 2,301 12 41,950 39,396 2,554 6 Free cash flow (2) Broadband (6,614) (3,934) (2,680) (68) (7,905) (4,197) (3,708) (88) Telecom 4,987 5,135 (148) (3) 9,131 9,090 41 0 Corporate (1,367) (344) (1,023) (297) (1,541) (939) (602) (64) Free cash flow (2,994) 857 (3,851) (449) (315) 3,954 (4,269) (108) (1) External customers only. (2) A non-GAAP measure. See the Non-GAAP Measures section below for additional information and reconciliation to the most directly comparable GAAP measure. 18 -------------------------------------------------------------------------------- Table of Contents Select Operating Metrics As of June 30, 2011 2010 Change % Change Broadband Total residential subscribers (1) 105,100 103,600 (5) 1,500 1 % Broadband residential revenue-generating units (2) 240,600 233,000 (5) 7,600 3 Data 100,600 98,900 (5) 1,700 2 Video 64,100 60,200 (5) 3,900 6 Voice 75,900 73,900 (5) 2,000 3 Total business customers (3) 7,900 7,500 (5) 400 5 Telecom Voice revenue-generating units (4) 25,600 32,800 (7,200) (22) Total business customers (3) 7,700 8,200 (500) (6) (1) Total residential subscribers are customers who receive one or more residential data, video or voice services from one of our subsidiaries in the Broadband segment. (2) We can deliver multiple services to a customer. Accordingly, we maintain statistical data regarding RGUs for video, voice and data, in addition to the number of subscribers. For example, a single customer who purchases video, voice and data services would be reflected as three RGUs. (3) Total business customers are customers who receive business data, voice or video services and represent a distinct customer account. (4) Voice RGUs are residential customers who subscribe to one or more voice access lines. (5) During the third quarter of 2010, we revised our methodology of counting Broadband residential subscribers, RGUs and business customer counts. The revised methodology facilitates the consistent application of customer counts within the Broadband segment. Accordingly, the Broadband segment metrics previously reported for the second quarter of 2010 have been revised to conform to current practice. Consolidated Overview Revenue and Cost Structure Our Broadband segment has grown significantly in recent years and now contributes the majority of our consolidated operating revenues. As we maintain our focus on growing the Broadband segment, the Telecom segment contributes a smaller percentage of total revenues and adjusted EBITDA. However, the Telecom segment remains an important part of our long-term growth strategy and it continues to generate the majority of our net income and free cash flow because of lessened demand for new capital investment. Our long-term strategy remains to continue growing our Broadband operations to counter the industry-wide trend of declines in Telecom revenues. Operating Revenues Operating revenues in the Broadband segment increased $2,883 and $5,685 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The increase in Broadband operating revenues was attributed to the continued growth in residential and business services. Broadband residential revenues increased $1,177 and $2,034 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 as a result of a 3% increase in RGUs and higher pricing for video and data services. The launch of our ADTV video product in the Sacramento market in 2010 also contributed to the growth in residential revenue and RGUs. Broadband business revenues increased $1,746 and $3,790 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Business customers increased 5% as of June 30, 2011 compared to the prior year as a result of growth primarily in the Kansas City market. The variety of our product offerings and our ability to offer customized service packages to businesses of all sizes contributed to the current year growth in business revenue and will continue to provide us with new opportunities in the commercial market. Utilizing our existing fiber-optic network, we are able to acquire and serve a more diversified business customer base and create new long-term revenue opportunities, such as wireless carrier backhaul and data center services. Wireless carrier backhaul revenue increased $625 and $1,258 during the quarter and six-month period ended June 30, 2011, 19 -------------------------------------------------------------------------------- Table of Contents respectively, compared to the same periods in 2010. Growth in these services is expected to continue to contribute to the increase in business revenue as the demand for wireless data continues to grow. We will continue to invest in new opportunities as they emerge in order to develop and enhance the broadband infrastructure and the residential and business services we offer, while focusing on the generation of new customers and increasing residential penetration on our existing marketable homes. Operating revenues in the Telecom segment decreased $2,469 and $4,904 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Residential services decreased $1,086 and $2,362 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 and were largely impacted by our customers' migration toward alternative communication services, including those offered by our Broadband segment. This migration contributed to a 22% decline in the Telecom segment voice RGUs as of June 30, 2011 compared to 2010. Business revenues decreased $106 and $130 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 as a result of a 6% decline in business customers. However, the decline was mitigated by higher pricing for data services, which were implemented during the third quarter of 2010. The decrease in operating revenues for the Telecom segment was also impacted by the scheduled reduction in support received from the California High Cost Fund ("CHCF") of $510 and $1,020 during the quarter and six month period ended June 30, 2011, respectively, and the elimination of the transport interconnection charge ("TIC") as of January 1, 2011 which resulted in a decline in revenue of approximately $534 and $1,085 during the quarter and six month period ended June 30, 2011, respectively. See the Regulatory Matters section below for a further discussion regarding the regulatory subsidies we receive. The Telecom segment also provides wholesale access and other services to the Broadband segment, which enables the Broadband segment to offer high-speed Internet, VoIP, video and wireless backhaul services to some customers within SureWest Telephone's service area. These wholesale services are included as intersegment revenues and expenses in each of the respective segments and eliminated in the consolidated statements of operations. Operating Expenses Consolidated operating expenses, excluding depreciation and amortization, decreased $2,940 and $2,088 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. During the quarter ended June 30, 2011, SureWest Telephone filed an amended remittance form to recover certain regulatory fees paid to the Universal Service Administrative Company ("USAC"), the administrator of the Federal universal service fund ("USF"), for the year ended December 31, 2010 and the quarters ended March 31, 2011 and June 30, 2011. We expect to receive a refund of $906 from USAC during the third quarter of 2011 for the fees related to 2010. USF fees of $303 and $329 for the quarters ended March 31, 2011 and June 30, 2011, respectively, are expected to be refunded during the third quarter of 2012. In addition, SureWest Broadband recorded a $218 reduction to its USAC expense, during the quarter ended June 30, 2011, relating to revised estimates to interstate traffic. We expect these fees to be refunded during the third quarter of 2012. As a result, during the quarter and six-month period ended June 30, 2011, we recognized a reduction in operating expense on the condensed consolidated statements of operations of $1,427 for the fees related to 2010 and the quarter ended March 31, 2011. This resulted in an increase in consolidated net income of $1,042 ($0.08 per share) for the quarter ended June 30, 2011 and decreased consolidated net loss of $1,156 ($0.08 per share) for the six months ended June 30, 2011. See the Other Adjustments section below for a further discussion regarding this matter. The decrease in consolidated operating expenses was also due to cost savings realized from the workforce reduction initiative implemented during the quarter ended June 30, 2010 in which approximately 60 positions were eliminated in order to improve operating efficiencies and align our operating costs with the decline in Telecom revenues. Affected employees were provided a range of benefits and resources, including severance. As a result, severance and other related termination costs of approximately $1,640 were incurred during the quarter and six-month period ended June 30, 2010. However, the decline in labor costs was mitigated by severance costs of $1,100, which included share-based compensation expense of $859, incurred as a result of the retirement of an executive officer during the six-month period ended June 30, 2011. Cost of services and products expense decreased $957 during the quarter and increased $687 during the six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease during the quarter ended June 30, 2011 was primarily due to a reduction in USAC expense resulting from the recovery of USF fees of $1,427 related to 2010 and the quarter ended March 31, 2011. The quarter and six-month periods ended June 30, 2011 were also largely affected by increases in programming and network costs related to providing video and data 20 -------------------------------------------------------------------------------- Table of Contents services. These costs result from an increase in programming fees per subscriber and the growth in residential and business services. Customer operations and selling expense decreased $612 and $1,139 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Labor costs declined resulting from a reduction in headcount through the workforce reduction initiative implemented in 2010. Sales and advertising costs also declined as a result of additional advertising and promotions in the prior year period related to the launch of our ADTV video product. General and administrative expenses decreased $1,371 and $1,636 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 primarily as a result of employee severance costs of $1,146 incurred during the quarter ended June 30, 2010 related to the workforce reduction initiative and savings in labor costs as a result of the reduction in headcount. Other administrative expenses also declined as a result of continued cost reduction initiatives. However, these cost savings were mitigated in part by the severance costs of $1,100 for a retiring officer during the six-month period ended June 30, 2011. Our consolidated depreciation and amortization expense increased $1,095 and $1,764 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 primarily due to the continued expansion of the network and success-based capital projects undertaken within the residential and business broadband service territories. Income from Operations and Adjusted EBITDA Income from operations increased $2,259 and $1,105 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. As described above, income from operations increased primarily as a result of the continued growth in consolidated operating revenues and the reduction in operating expenses related to the USAC fees recorded during the current quarter. Adjusted EBITDA increased $2,301 and $2,554 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. We continued to maintain positive Adjusted EBITDA growth during the quarter and six-month period ended June 30, 2011 by successfully replacing the declines in the Telecom segment with growth in our Broadband segment and through cost savings as a result of the workforce reduction initiative implemented during the second quarter of 2010. Free Cash Flow Free cash flow decreased $3,851 and $4,269 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease was largely due to additional capital expenditures related to the expansion of our fiber network during the quarter ended June 30, 2011. In 2011, we have planned additional capital investments for network expansion which will include the addition of 15,500 fiber marketable homes in the Kansas City area and the upgrade of 6,800 copper homes within the telephone service area of the Incumbent Local Exchange Carrier ("ILEC") so that they will be video service capable. As of June 30, 2011, we added 5,400 of the planned fiber marketable homes in the Kansas City area and upgraded 3,400 of the planned homes in the ILEC territory. We expect capital expenditures and associated free cash flow to vary quarter to quarter based on the expansion of our fiber network in Kansas City and the resulting opportunities for additional residential and business services growth. Reclassifications Certain amounts in our 2010 condensed consolidated financial statements have been reclassified to conform to the presentation of our 2011 condensed consolidated financial statements. Operating expenses have been reclassified for a change during the third quarter of 2010 in the classification of customer technical support costs from customer operations and selling to cost of services and products. Prior period costs have been reclassified to conform to the current year presentation. In addition, the calculation of certain select operating metrics was revised during the third quarter of 2010 to reflect the consistent application of customer counts within the Broadband segment. Accordingly, where necessary, prior period metric calculations have been revised to conform to current practice. Other Adjustments Our subsidiaries provide services to customers for which they are required to contribute to the universal service fund. Each subsidiary collects USF fees from its customers and we remit these amounts to the USAC, the administrator of the Federal USF. SureWest Telephone provides wholesale transport services to SureWest Broadband, 21 -------------------------------------------------------------------------------- Table of Contents which SureWest Broadband resells to its own customers. The SureWest Broadband voice services are subject to USF fees. During the quarter ended June 30, 2011, we determined that SureWest Telephone remitted USF fees to USAC relating to the wholesale transport for voice services which it sells to SureWest Broadband for the year ended December 31, 2010 and the quarters ended March 31, 2011 and June 30, 2011. We also determined that SureWest Broadband also had remitted USF fees to USAC relating to the voice services provided to its customers during the same time periods, including those services utilizing SureWest Telephone wholesale transport. Wholesale transport services provided by SureWest Telephone to SureWest Broadband for the resale as voice services are not subject to USF fees for SureWest Telephone, generally because USF contributions are being collected from the end user customers of SureWest Broadband who use these resold wholesale services. Accordingly, on June 3, 2011, SureWest Telephone filed an amended remittance form with USAC to recover the fees paid of $906 for the year ended December 31, 2010. We expect to receive a refund from USAC during the third quarter of 2011 for the fees related to 2010. The USF fees of $303 and $329 for the quarters ended March 31, 2011 and June 30, 2011, respectively, will be refunded to SureWest Telephone based on its annual remittance form to be filed with USAC during the first quarter of 2012. In addition, SureWest Broadband recorded a $218 reduction to its USAC expense during the quarter ended June 30, 2011 relating to revised estimates to its interstate traffic. We expect to receive the refunds relating to the six months ended June 30, 2011 during the third quarter of 2012. For the fees relating to 2010 and the quarter ended March 31, 2011, we recognized a reduction in operating expense (within costs of services and products) on the condensed consolidated statements of operations of $1,427 during the quarter and six-month period ended June 30, 2011. This resulted in an increase in consolidated net income of $1,042 ($0.08 per share) for the quarter ended June 30, 2011 and decreased consolidated net loss by $1,156 ($0.08 per share) for the six months ended June 30, 2011 and a corresponding short-term and long-term receivable of $906 and $850, respectively, on the condensed consolidated balance sheets. Segment Results of Operations Broadband Quarter Ended June 30, Six Months Ended June 30, $ % $ % 2011 2010 Change Change 2011 2010 Change Change Data $ 12,636 $ 12,145 $ 491 4 % $ 25,152 $ 24,393 $ 759 3 % Video 12,867 12,166 701 6 25,656 24,385 1,271 5 Voice 6,585 6,600 (15) (0) 13,111 13,107 4 0 Total residential revenues 32,088 30,911 1,177 4 63,919 61,885 2,034 3 Business 12,999 11,253 1,746 16 25,613 21,823 3,790 17 Access 504 541 (37) (7) 1,060 1,268 (208) (16) Other 368 371 (3) (1) 746 677 69 10 Total operating revenues from external customers 45,959 43,076 2,883 7 91,338 85,653 5,685 7 Intersegment revenues 155 145 10 7 315 313 2 1 Operating expenses Cost of services and products(1) 26,011 25,269 742 3 52,334 49,289 3,045 6 Customer operations and selling 5,320 5,982 (662) (11) 10,371 11,946 (1,575) (13) General and administrative 4,293 4,752 (459) (10) 9,256 9,905 (649) (7) Depreciation and amortization 13,098 12,140 958 8 25,786 24,320 1,466 6 Loss from operations (2,608) (4,922) 2,314 47 (6,094) (9,494) 3,400 36 Net loss (3,006) (4,269) 1,263 30 (7,411) (7,989) 578 7 Adjusted EBITDA(2) 11,397 8,409 2,988 36 21,730 16,608 5,122 31 (1) Exclusive of depreciation and amortization. (2) A non-GAAP measure. See the Non-GAAP Measures section below for additional information and reconciliation to the most directly comparable GAAP measure. Broadband Segment Overview Adjusted EBITDA and loss from operations for the Broadband segment continued to improve during the quarter and six-month period ended June 30, 2011 compared to the same periods in 2010 and is reflective of our long-term 22 -------------------------------------------------------------------------------- Table of Contents strategy to invest in and grow the Broadband business. The investment in our network over the last several years has created a technologically-advanced service platform, which enables us to grow revenues through increased penetration of a broad range of network facilities and services, as well as to create new long-term revenue opportunities with only nominal capital expenditures. We continue to successfully migrate Telecom customers to our Broadband VoIP product mitigating the loss of Telecom voice RGUs. The successful launch during 2010 of our ADTV product in the Sacramento market and switched digital video and DOCSIS 3.0 in our Kansas City market has enabled us to capture customers who seek the high data speeds and enhanced products our network can provide. As a result, data, video and voice revenues continued to increase for both residential and business services. Growth in business revenues significantly contributed to the increase in adjusted EBITDA during the quarter and six-month period ended June 30, 2011 compared to the same periods in 2010 as a result of an increase in wireless carrier backhaul and data center services and a 5% increase in business customers. We anticipate continued growth in both data center and wireless carrier backhaul services as consumer demand for managed services and wireless data continues to increase. In addition, during the quarter ended June 30, 2010, we implemented a strategic restructuring designed to improve operating efficiencies and enhance our focus on the growth of the Broadband segment. This cost cutting initiative resulted in cost savings as a result of a reduction in the workforce and reduced professional fees. Broadband Segment Operating Revenues Residential Revenues Broadband residential revenues increased $1,177 and $2,034 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The increase in residential revenues was due in part to the 3% growth in Broadband residential RGUs as of June 30, 2011 compared to 2010. Broadband residential revenues also increased as a result of higher pricing for video and data services implemented in September 2010. We are realizing the benefits of the investment we made in our network over the last several years. Our fiber network in the Sacramento region enables us to cost effectively provide customers with faster data speeds, offer new services and upgrade existing services as we continue to enhance the value of our broadband services for our customers. The launch of DOCSIS 3.0 in our Kansas City market in 2010 significantly enhanced our hybrid fiber coaxial ("HFC") network, which enables us to offer our customers faster data speeds and additional HD channels. The success of our ADTV product in our Sacramento market has resulted in higher take rates for our triple-play services as a bundled package. We anticipate continued growth in residential broadband RGUs resulting from our VoIP phone service, our ADTV product and an increase in residential fiber marketable homes in 2011 through the expansion of our network in our Kansas City market and through the enhancement of our copper network in the Sacramento market. Data We offer high speed Internet access at symmetrical speeds of up to 50 Mbps, depending on the nature of the network facilities that are available, the level of service selected and the location. The reliability and high speeds of the data service in both the Sacramento and Kansas City markets enhance other services such as VoIP and Digital Phone, where customers manage phone services through the online SureWest portal. Through the SureWest portal, customers can manage their VoIP or Digital Phone service and access a variety of value added features and enhancements that are designed to take advantage of the speed of the Internet service we provide. Our residential data revenues increased $491 and $759 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 primarily as a result of a 2% increase in data RGUs and a 2% increase in average monthly revenue per user ("ARPU") as a result of higher price points on our data services, as discussed above. Video Our video services range from limited basic service to our newest product offering ADTV, which launched in January 2010. ADTV is currently deployed through our copper and fiber networks in the greater Sacramento region. The integration of the new Mediaroom™ platform includes a Whole Home DVR, which allows customers the ability to watch recorded shows on any television in the house, record multiple shows at one time and utilize an intuitive on-screen guide and user interface. During the quarter ended June 30, 2011, we successfully upgraded our Mediaroom™ platform to enhance many of our existing features and to provide future product enhancements. In addition to the ability to watch recorded shows on any television in the house, customers can now pause, rewind and fast-forward live programs on all televisions in the home. Our services are delivered utilizing FTTH and FTTN networks, which 23 -------------------------------------------------------------------------------- Table of Contents allows us to offer a high quality experience with digital TV packages. Our full digital video package provides access to approximately 330 and 327 channels in our California and Kansas City markets, respectively, including premium and pay-per-view channels, VOD service, premium VOD channels, music channels and an interactive, on-screen program guide. Digital video subscribers can also subscribe to additional services, including a DVR and HDTV. As of June 30, 2011, our customers had access to 74 and 68 HD channels in our California and Kansas City markets, respectively. Residential video revenues increased $701 and $1,271 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Revenues increased as a result of a 6% increase in video RGUs and higher pricing on many of our video service offerings, as discussed above. We continue to enhance the subscriber value for our broadband services by offering new products and features including ADTV, a Whole Home DVR, faster data speeds and additional channels including premium, VOD and HD channels. In addition, during 2011, we are enhancing our copper network in the Sacramento region which will allow us to upgrade an additional 6,800 copper homes within the ILEC service territory to be video capable and offer access to our ADTV service. As of June 30, 2011, we have completed upgrades to 3,400 homes on the copper network. Voice We offer phone services that provide local and long-distance calling and include features such as caller ID and call waiting. Our VoIP phone service is offered in the Sacramento market and is available in packages ranging from basic telephone service to unlimited local and domestic long distance calling plans. Nearly all of our VoIP phone service plans include enhanced calling features such as caller ID on TV, Find Me/Follow Me, sequential ringing and selective call acceptance and rejection. Voice RGUs in the Sacramento market increased 7% as of June 30, 2011 compared to the same period in 2010. As of June 30, 2011, approximately 19% of the homes in our Sacramento market have subscribed to our VoIP phone service. Our VoIP phone service in the Sacramento market offers our customers, including those in the Telecom service territory, an alternative to traditional circuit switched land line service and presents our customers with a more competitive triple-play offering with increased options and multiple packages. Residential voice revenues were relatively flat during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Although voice RGUs increased 3% as of June 30, 2011 compared to the same period in 2010, the change in voice revenues was mitigated by a decline in ARPU as a result of promotional discounts during the quarter and six-month period ended June 30, 2011. Business Revenues We provide a variety of business communications services to small, medium and large business customers. The services we offer to our business customers include: fiber-optics-based high-speed Internet, customized data and Ethernet transport services, data center and disaster recovery solutions, traditional landline and VoIP phone services, wireless backhaul and digital TV. Business revenues increased $1,746 and $3,790 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 due primarily to a 5% increase in business customers during the same periods. ARPU also increased 10% as of June 30, 2011 compared to the same period in 2010, primarily due to increases in wireless backhaul services. Wireless backhaul revenue increased $625 and $1,258 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. We anticipate backhaul revenue will continue to grow as wireless carriers, faced with escalating consumer and business demand for mobile broadband connectivity, are forced to expand and improve their networks, and to replace existing backhaul facilities with new facilities capable of handling more traffic at faster rates. Our existing fiber-optic network provides the capacity to secure new wireless carrier backhaul agreements and create new long-term revenue opportunities without significant additional capital expenditures. Access Revenues Access revenues decreased $37 and $208 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease was mostly attributable to cash settlements received during the six months ended June 30, 2010 from certain telecommunications carriers relating to disputed carrier access charges. 24 -------------------------------------------------------------------------------- Table of Contents Broadband Segment Operating Expenses Total operating expenses in the Broadband segment, excluding depreciation and amortization, decreased $379 and increased $821 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Cost of services and products (exclusive of depreciation and amortization) increased $742 and $3,045 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The increase in costs in the current year was largely due to direct costs incurred to provide our voice, video and data services. Video programming fees are paid to programming networks to license the programming we distribute to our video customers. Video programming costs continue to increase due to the growth in residential video RGUs, the expansion of channels offered and an increase in costs on a per subscriber basis and per program channel, particularly for sports and HD channels. We also incur network access and transport costs to provide data and voice services to our customers. Transport costs increased as a result of growth in our business customer base. In addition, due to the rising demand for our VoIP product in the Sacramento market and the additional capacity required to handle the increasing volume of data usage, network access costs have increased in the current year period. Network access costs include costs paid to external vendors as well as our Telecom segment, in accordance with the provisions of a wholesale access agreement. The wholesale access agreement enables the Broadband segment to offer high-speed Internet, VoIP, video and wireless backhaul services to its customers within the Telecom segment territory. Customer operations expense decreased $662 and $1,575 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in costs was primarily due to a decline in labor costs resulting from a reduction in headcount through the workforce reduction initiative implemented during the quarter ended June 30, 2010. Selling and advertising costs, including radio advertising, promotional materials and temporary sales labor, also decreased as a result of additional costs in the prior year quarter to promote the launch of our new ADTV product. General and administrative expense decreased $459 and $649 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in costs was primarily due to (i) a decline in labor costs resulting from a reduction in headcount, (ii) a decrease in professional fees, (iii) a reduction in information technology costs related to system maintenance and development and (iv) severance costs of approximately $558 incurred during the quarter ended June 30, 2010 related to the workforce reduction initiative. However, these cost savings were mitigated in part by severance costs including share-based compensation expense incurred during the six months ended June 30, 2011 for a retiring officer. Depreciation and amortization expense increased $958 and $1,466 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 due primarily to the continued expansion and enhancement of the broadband network and success-based capital projects. 25 -------------------------------------------------------------------------------- Table of Contents Telecom Quarter Ended June 30, Six Months Ended June 30, $ % $ % 2011 2010 Change Change 2011 2010 Change Change Residential $ 3,393 $ 4,479 $ (1,086) (24) % $ 6,985 $ 9,347 $ (2,362) (25) % Business 8,294 8,400 (106) (1) 16,688 16,818 (130) (1) Access 3,148 4,408 (1,260) (29) 6,202 8,568 (2,366) (28) Other 168 185 (17) (9) 304 350 (46) (13) Total operating revenues from external customers 15,003 17,472 (2,469) (14) 30,179 35,083 (4,904) (14) Intersegment revenues 5,052 5,091 (39) (1) 10,348 10,010 338 3 Operating expenses Cost of services and products(1) 4,066 5,753 (1,687) (29) 9,818 11,730 (1,912) (16) Customer operations and selling 2,601 2,581 20 1 5,049 4,699 350 7 General and administrative 3,225 4,148 (923) (22) 6,936 7,943 (1,007) (13) Depreciation and amortization 3,259 3,122 137 4 6,346 6,048 298 5 Income from operations 6,904 6,959 (55) (1) 12,378 14,673 (2,295) (16) Net income 4,326 3,742 584 16 7,087 7,989 (902) (11) Adjusted EBITDA(2) 10,832 11,519 (687) (6) 20,220 22,788 (2,568) (11) (1) Exclusive of depreciation and amortization. (2) A non-GAAP measure. See the Non-GAAP Measures section below for additional information and reconciliation to the most directly comparable GAAP measure. Telecom Segment Overview Telecom revenues continue to experience an overall decline resulting from an industry-wide trend of access line attrition and scheduled reductions in the subsidies we receive from governmental regulatory agencies. Access revenues will continue to decline through 2011 due to scheduled reductions in the CHCF subsidy and the elimination of transport interconnection revenue, which was effective January 1, 2011. However, we anticipate Telecom revenue declines to slow over the next several years as the scheduled phased reductions of our subsidies are completed and access line losses level off. Revenues earned by the Telecom segment through a wholesale access agreement with the Broadband segment increased during the quarter and six-month period ended June 30, 2011 compared to the same periods in 2010. We anticipate the wholesale revenue stream to continue to trend favorably as consumers within the Telecom segment service territory continue to demand more broadband services. As technology and the regulatory environment changes within the communications industry, the Telecom segment will increasingly consist of services that generate higher margins such as business and wholesale services. Business and wholesale services comprised 67% of total Telecom revenues at June 30, 2011 compared to 59% during the same period in 2010. The Telecom segment continues to contribute the majority of our net income and free cash flow. Telecom Segment Operating Revenues Residential Revenues SureWest Telephone offers several different phone service options, from basic local service packages to unlimited California and nationwide flat-rate plans. All of the plans include options for voicemail and other calling features such as caller ID and call forwarding. SureWest Telephone residential revenues decreased $1,086 and $2,362 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 as we continue to be impacted by the industry-wide decline in residential access lines and competition from wireless, wireline, and digital phone competitors (including SureWest Broadband). Residential voice RGUs declined 22% as of June 30, 2011 compared to the same period in 2010. We continue to mitigate additional voice access line and operating revenue losses through our VoIP phone service offered to customers within the Telecom service area through our Broadband segment. As a result, we expect a portion of the Telecom segment's voice revenue will 26 -------------------------------------------------------------------------------- Table of Contents continue to shift to the VoIP service being offered by our Broadband segment. As of June 30, 2011, 40% of the decline in Telecom voice RGUs in 2011 was due to customers who have transferred to SureWest Broadband's VoIP phone service rather than moving to competitors. See the Broadband segment residential revenue section above for a more detailed discussion regarding VoIP and other services offered by SureWest Broadband. Business Revenues We provide a variety of business service offerings to small, medium and large business customers, including many services over our advanced fiber network. The services we offer to our business customers include, but are not limited to high-speed Internet, customized data and Ethernet transport services, data center and disaster recovery solutions, traditional landline and scalable IP communication systems. SureWest Telephone business revenues decreased $106 and $130 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in revenue was primarily due to a 6% decline in business customers which resulted from the strained economic conditions for small and medium sized businesses and continued strong competitive pressures, as discussed above. The decrease in business revenue was mitigated in part by a price increase for data services implemented during the third quarter of 2010 resulting in a 5% increase to ARPU as of June 30, 2011 compared to the same period in 2010. Access Revenues Access revenues, which include interstate and intrastate switched access revenue, interstate common line ("CL") revenue and support payments from the CHCF, decreased $1,260 and $2,366 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. As anticipated, scheduled reductions in subsidies received from the CHCF resulted in support received during the quarter and six-month period ended June 30, 2011 to decrease $510 and $1,020, respectively, compared to the same periods in 2010. Switched access revenue also decreased $668 and $1,406 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010, primarily due to the elimination of an intrastate access element, or TIC, effective January 1, 2011. See the Regulatory Matters section below for a more detailed discussion regarding SureWest Telephone's regulated revenues. Intersegment Revenues Intersegment revenues consist predominately of revenues earned through a wholesale access agreement between the Telecom and Broadband segments. The Telecom segment supplies wholesale access services through its network to the Broadband segment, which enables the Broadband segment to offer high-speed Internet, VoIP, video and wireless backhaul services to customers residing within the Telecom service territory. Wholesale access and Digital Subscriber Line ("DSL") intersegment revenue increased $335 and $724 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010 and is anticipated to continue to increase with heightened demand for the Broadband segment's VoIP and ADTV products offered in the Telecom segment service territory. See the Broadband operating revenue section above for more detailed discussion of the Broadband revenues and product offerings. Telecom Segment Operating Expenses Total operating expenses for the Telecom segment, excluding depreciation and amortization, decreased $2,590 and $2,569 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. Cost of services and products (exclusive of depreciation and amortization) decreased $1,687 and $1,912 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. USAC expense decreased as a result of the recovery during the current quarter of USF fees of $1,209 related to 2010 and the quarter ended March 31, 2011. See the Other Adjustments section in Consolidated Overview above for additional information regarding this matter. In addition, costs to support local and long distance services decreased as a result of the decline in residential voice RGUs and business customers. Customer operations expense increased $20 and $350 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The increase in the current year period was mostly attributable to an increase in advertising, promotion, and sales force costs to support product offerings in the Telecom segment service territory. 27 -------------------------------------------------------------------------------- Table of Contents General and administrative expense decreased $923 and $1,007 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in costs in the current year period was primarily due to (i) employee severance costs of $588 incurred during the quarter ended June 30, 2010 and (ii) a decline in labor costs resulting from a reduction in headcount. However, these cost savings were mitigated in part by severance costs including share-based compensation expense incurred for a retiring officer during the six-month period ended June 30, 2011. Depreciation and amortization expense increased $137 and $298 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The increase is primarily from upgrades to the copper network and digital VoIP equipment installations for customers within the ILEC territory. Regulatory Matters Revenues subject to broad Federal or state regulation, which include such telecommunications services as local telephone service, network access service and toll service, are derived from various sources, including: † business and residential subscribers of basic exchange services; † surcharges mandated by state commissions; † long distance carriers, for network access service; † competitive access providers and commercial enterprises for network access service; † interstate pool settlements from NECA; † support payments from federal or state programs; and † support payments from the CHCF, recovering costs of services including extended area service. Certain of our interstate telecommunications service rates are subject to regulation by the Federal Communications Commission ("FCC"). Interstate switched and special access rates are established through a SureWest Telephone tariff filed with the FCC. For interstate CL charges, SureWest Telephone concurs with tariffs filed by National Exchange Carrier Association ("NECA"). Intrastate service rates are subject to regulation by state commissions. Prices for intrastate telecommunications services are established through tariffs or through other regulatory mechanisms, including, in California, service guides. Pending and future regulatory actions may have a material impact on our consolidated financial position and results of operations. FCC Matters Under current FCC rules governing rate making, SureWest Telephone is required to establish rates for its interstate telecommunications services based on projected demand usage for the various services. SureWest Telephone projects its earnings through the use of annual cost separation studies, which utilize estimated total cost information and projected demand usage. Carriers are required to follow FCC rules in the preparation of these annual studies. SureWest Telephone determines actual earnings from its interstate rates as actual volumes and costs become known. The FCC monitors SureWest Telephone's interstate earnings. In an April 6, 2010 decision, a Federal appeals court found that the FCC lacked authority over certain Internet-related practices of Comcast. This decision came during a proceeding that had been initiated by the FCC to adopt rules related to the conduct of providers of retail Internet services. Notwithstanding the Federal appeals court decision, on December 21, 2010, the FCC adopted rules requiring that such providers honor certain operating principles, including principles of (i) transparency, (ii) no blocking, (iii) no unreasonable discrimination and (iv) reasonable network management in connection with their Internet services. However, those rules have not yet taken effect. In addition, the FCC initiated action on February 8, 2011 to again consider reform of the current structure for intercarrier compensation and to consider rules for transitioning the current universal service fund to support broadband deployment. New rounds of comments were filed in April and May 2011,with ongoing followup advocacy filings and meetings. It is unclear whether and when the FCC will take actions on these matters. The FCC's actions in these and future proceedings could significantly alter the structure of these arrangements, and affect the costs and sources or revenue for affected service providers. Action in any of these proceedings could have a material impact on us. We will continue to monitor these matters, participate in them as we deem appropriate, and assess the potential impact on our consolidated financial position and results of operations. California Public Utility Commission ("CPUC") Matters A CPUC decision in August 2005 allowed SureWest Telephone to continue receiving our $11,500 annual draw from the CHCF on an interim basis pending further CPUC action. The CHCF was previously authorized by the CPUC to 28 -------------------------------------------------------------------------------- Table of Contents offset SureWest Telephone's intrastate regulated operating expenses on an interim basis. In August 2006, we requested permission from the CPUC to implement a graduated phase-down of our annual $11,500 interim draw. In September 2007, the CPUC issued Decision 07-09-002 which provides for SureWest Telephone to phase-down its interim annual CHCF draw over a five-year period. The phase-down of the interim draw began in January 2007, initially reducing the annual $11,500 interim draw to $10,200, and in each subsequent year will be incrementally reduced by $2,040. In 2010 our interim CHCF draw was $4,080. We anticipate our 2011 interim CHCF draw will be $2,040. In an ongoing proceeding relating to the New Regulatory Framework (under which SureWest Telephone has been regulated since 1996), the CPUC adopted Decision 06-08-030 in 2006, which grants carriers broader pricing freedom in the provision of telecommunications services, bundling of services, promotions and customer contracts. This decision adopted a new regulatory framework, the Uniform Regulatory Framework ("URF"), which among other things (i) eliminates price regulation and allows full pricing flexibility for all new and retail services except basic residential services, which limits increases to $3.25 per year during 2009 and 2010, (ii) allows new forms of bundles and promotional packages of telecommunication services, (iii) allocates all gains and losses from the sale of assets to shareholders and (iv) eliminates almost all elements of rate of return regulation, including the calculation of shareable earnings. Beginning January 1, 2011, each URF ILEC is allowed full pricing flexibility for the basic residential rate. On December 31, 2010, the CPUC issued a ruling to initiate a new proceeding to assess whether, or to what extent, the level of competition in the telecommunications industry is sufficient to control prices for the four largest ILECs in the state, including SureWest Telephone, however this proceeding has been placed on hold. The CPUC's actions in this and future proceedings could lead to new rules and an increase in government regulation. In December 2007, the CPUC issued a final decision in a proceeding investigating the continued need for an intrastate access element called the TIC. The final decision capped SureWest Telephone's intrastate access charges through 2010 and the TIC was eliminated effective January 1, 2011. SureWest Telephone will have an opportunity to recover all or part of our lost TIC revenue elsewhere, including residential rate adjustments, as well as through growth of our Broadband segment. We anticipate a reduction in our 2011 intrastate access revenues of approximately $2,050. Other Regulatory Matters We are also subject to a number of regulatory proceedings occurring at the federal and state levels that may have a material impact on our operations. The FCC and state commissions have authority to issue rules and regulations related to our business. A number of proceedings are pending or anticipated that are related to such telecommunications issues as competition, interconnection, access charges, intercarrier compensation, broadband deployment, consumer protection and universal service reform. Some proceedings may authorize new services to compete with our existing services. Proceedings that relate to our cable television operations include rulemakings on set top boxes, carriage of programming, industry consolidation and ways to promote additional competition. There are various on-going legal challenges to the scope or validity of FCC orders that have been issued. As a result, it is not yet possible to determine fully the impact of the related FCC rules and regulations on our operations. Non-Operating Items Other Income and Expense, Net Consolidated interest expense increased $364 and $3,137 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. In March 2011, we entered into a Credit Agreement to refinance our existing long-term debt, as described in the Liquidity and Capital Resources section below. As a result of entering into the Credit Agreement, we recognized debt issuance costs of $301 and incurred early termination fees of $2,346 related to the repayment of our Series A and Series B Senior Notes during the six-month period ended June 30, 2011. We received patronage dividends of $902 and $979 during the quarters ended March 31, 2011 and 2010, respectively. We earn patronage dividends from CoBank, ACB ("CoBank") based on our share of the net income earned by CoBank. We record the receipt of the patronage dividends against interest expense. Income Taxes Income taxes increased $294 and decreased $1,092 during the quarter and six-month period ended June 30, 2011, respectively, compared to the same periods in 2010. The decrease in income taxes during the six-month comparable periods was due primarily to increases in interest expense and state deferred income taxes related to apportionment 29 -------------------------------------------------------------------------------- Table of Contents factor changes in 2010 resulting from the acquisition of our Kansas City operation. Changes in state apportionment factors, based on operational results, may affect future effective tax rates. The effective federal and state income tax rates were 19.4% and 100.0% for the six-month periods ended June 30, 2011 and 2010, respectively. The decrease in the effective tax rate in the current year compared to the prior year was due primarily to a reduction in permanent differences related to state income taxes resulting from apportionment factor changes that occurred during 2010. Non-GAAP Measures In addition to the results reported in accordance with US GAAP, we also use certain non-GAAP measures including Adjusted EBITDA and free cash flow to evaluate operating performance and to facilitate the comparison of our historical results and trends. These non-GAAP measures are also used to manage and evaluate the operating performance of our reportable segments. These financial measures are not a measure of financial performance under US GAAP and should not be considered in isolation or as a substitute for net income (loss) as a measure of performance and net cash provided by operating activities as a measure of liquidity. The calculation of these non-GAAP measures may not be comparable to similarly titled measures used by other companies. Reconciliations to the most directly comparable GAAP measure are provided below. Adjusted EBITDA Adjusted EBITDA represents net income (loss) excluding amounts for income taxes; depreciation and amortization; non-cash pension and certain post-retirement benefits; non-cash stock compensation; severance and other related termination costs; and all other non-operating income and expenses. Adjusted EBITDA is a common measure of operating performance in the telecommunications industry. Adjusted EBITDA helps us evaluate our performance by removing from our operating results non-cash items and items which do not relate to our core operating performance. The following tables are a reconciliation of net income (loss) to Adjusted EBITDA for the quarters and six-month periods ended June 30, 2011 and 2010: |