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WINDSTREAM CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[November 08, 2012]

WINDSTREAM CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

(Edgar Glimpses Via Acquire Media NewsEdge) Unless the context requires otherwise, the use of the terms "Windstream," "we," "us" and "our" in this Management's Discussion and Analysis refers to Windstream Corporation and its consolidated subsidiaries.

The following sections provide an overview of our results of operations and highlight key trends and uncertainties in our business. Certain statements constitute forward-looking statements. See "Forward-Looking Statements" at the end of this discussion for additional factors relating to such statements, and see "Risk Factors" in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the Securities and Exchange Commission ("SEC") on February 22, 2012, for a discussion of certain risk factors applicable to our business, financial condition and results of operations.

Effective during the fourth quarter of 2011, we changed our method of recognizing actuarial gains and losses for pension benefits to recognize actuarial gains and losses in our operating results in the year in which the gains and losses occur. We have retrospectively adjusted financial information for all prior periods presented to reflect our voluntary change in accounting policy for pension benefits. We also elected to revise historical results for certain previously unrecorded immaterial errors and concluded that the effects, individually and in the aggregate, are immaterial to the unaudited quarterly financial information. See Notes 2 and 8 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011. Additionally, certain prior year amounts have been reclassified to conform to the current year financial statement presentation. These reclassifications did not impact net or comprehensive income.


OVERVIEW We are a leading provider of advanced communications and technology solutions, including managed services and cloud computing, to businesses nationwide. In addition to business services, we offer broadband, voice and video services to consumers in primarily rural markets. We have operations in 48 states and the District of Columbia, a local and long-haul fiber network spanning approximately 115,000 miles, a robust business sales division and 23 data centers offering managed services and cloud computing.

STRATEGY During 2012, we continue to make significant progress on our strategy to grow business and consumer broadband revenues to offset continuing pressure on our consumer voice and long-distance revenues and intercarrier compensation.

Revenues from businesses and consumer broadband were 69.0 percent and 68.5 percent of total revenues for the three and nine month periods ended September 30, 2012, respectively, as compared to 60.5 percent and 60.0 percent for the same period in 2011.

Our strategy has been and continues to be transformation of our business from a rural, consumer-focused voice and broadband provider into a national provider of advanced communications and technology solutions to businesses. The key elements of this strategy include: Transformation of our business Today, we are a very different company from the one that was created in 2006 through the spinoff from Alltel Corporation. We operated in just 16 states with less than 24,000 miles of fiber, a modest business sales organization and only a handful of lower-tier data centers. We faced challenges as consumers abandoned wireline voice connections in favor of wireless services, and cable television companies were increasingly competing for both voice and Internet customers.

To manage these pressures and improve our size, scale and cost structure, we completed three targeted acquisitions of other traditional telephone companies between 2006 and 2009. In early 2010, we made a critical move to accelerate the transformation of the company when we acquired NuVox Inc. ("NuVox"), a leading regional business services provider based in Greenville, South Carolina. NuVox added a broad portfolio of Internet protocol ("IP") based services and an aggressive sales force, and this acquisition marked an important step in positioning the company to better serve business customers.

42 -------------------------------------------------------------------------------- Table of Contents We completed three additional acquisitions in 2010, Iowa Telecommunications Services, Inc. ("Iowa Telecom"), Hosted Solutions Acquisitions, LLC ("Hosted Solutions") and Q-Comm Corporation ("Q-Comm"), which expanded our operating presence in contiguous markets in the midwestern United States, added the infrastructure to offer advanced data services and expanded our fiber network.

In 2011, we completed the acquisition of PAETEC Holding Corp ("PAETEC"), a communications carrier focused on business customers. The PAETEC acquisition creates a nationwide fiber network and advances our strategy to shift our revenue mix towards strategic growth areas, including business and fiber transport services. It adds an attractive base of medium-sized to large-sized business customers, seven data centers and 36,700 fiber miles. In addition, the PAETEC transaction provides opportunities for approximately $100.0 million in pre-tax operating cost synergies and $10.0 million in capital synergies.

Investing for growth We have made significant investments in our network to expand our business service offerings and increase broadband speeds and capacity in our consumer markets in response to public demand for faster Internet speeds. The expansion of our fiber transport network, through acquisitions and organic growth, enhances our ability to provide wireless transport, or backhaul services. We expect wireless data usage to continue to increase, which will drive the need for additional wireless backhaul capacity. We are also making significant investments in data centers to broaden the technology-based services we offer, including cloud [[Image Removed]] computing and managed services.

Focus on business and broadband services As our consumer business remains under pressure due to competition, we remain squarely focused on expanding business and broadband services, as further discussed below, to drive top-line growth. By doing so, we expect to continue to create significant value for both our customers and our shareholders.

Together, these initiatives align our focus with the growth opportunities in our industry and provide investors with the opportunity to combine growth and a high-yield dividend.

EXECUTIVE SUMMARY Key activities during the nine months ended September 30, 2012 included: • continued activities around the integration of PAETEC, which turned us into a national provider of business services and included an attractive customer base of medium and large businesses and significantly enhanced our capabilities in strategic growth areas, including IP based services, cloud computing and managed services; • continued focus on revenue growth opportunities in our business service areas; • made significant success-based capital investments in our fiber network, designed to accommodate network capacity requirements for wireless carriers as a result of growing wireless data usage; • completed the review of our management structure to increase the efficiency of decision-making and position ourselves for continued success, where approximately 350 management positions were eliminated, resulting in annualized savings of approximately $40 million; • amended and restated our existing senior secured credit facilities effective August 8, 2012, providing for the incurrence of up to $900.0 million of additional term loans, allowing us to repay our revolving line of credit and create sufficient liquidity to repay our 2013 debt maturities; 43 -------------------------------------------------------------------------------- Table of Contents • paid off all $300.0 million of the PAETEC 2015 Notes, resulting in lower future interest costs and amended and restated our existing senior secured credit facilities to provide for the incurrence of $280.0 million of additional term loans, extended the maturity of existing term loans and increased secured debt capacity to 2.25 times adjusted Operating Income before Depreciation and Amortization ("OIBDA"), as defined per the credit facility; • opened new state-of-the-art data centers in Little Rock, Arkansas, and McLean, Virginia, which meet the growing business demand for cloud-based and dedicated managed services and underscore our commitment to our growing business customer base nationwide; • implemented new depreciation rates for certain subsidiaries, resulting in a net increase to depreciation expense of $44.7 million for the nine months ended September 30, 2012.

These activities, in conjunction with the strategic acquisitions we completed in prior years, further our transformation from a traditional telephone company into an advanced communications and technology provider. As a result of these strategic activities, our revenue mix has shifted significantly toward our growth areas.

BUSINESS TRENDS The following discussion highlights key trends affecting our business.

Business communications services: Demand for advanced communications services is expected to drive growth in revenues from business customers. To meet this demand, we continue to expand our capabilities in integrated voice and data services, which deliver voice and broadband services over a single Internet connection. We also offer multi-site networking services which provide a fast and private connection between business locations as well as a variety of other data services. We view this as a strategic growth area, but we are subject to competition from other carriers and cable television companies, which could suppress growth. See "Competition" in Item 1 of Part I of our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC on February 22, 2012, for more details.

Data center services: Many businesses are moving towards cloud computing and managed services as an alternative to a traditional information technology infrastructure. Our data centers are capable of delivering those services, and we are actively investing in data center expansion in order to meet the growing demand for these types of services. In addition to cloud computing and managed services, our data centers offer colocation services, in which we provide a safe, secure environment for storage of servers and networking equipment.

Wireless backhaul: As wireless data usage grows, wireless carriers need additional bandwidth on the wireline network to accommodate the additional wireless traffic. We have made significant success-based capital investments to provide backhaul services to wireless carriers. These investments include building out fiber to new wireless towers and replacing copper facilities with fiber facilities to wireless towers we already serve. During the three and nine month periods ended September 30, 2012, we spent approximately $76.2 million and $206.2 million, respectively, in fiber-to-the-tower investments and we expect to continue to make significant success-based capital investments during 2012 to offer additional wireless backhaul services to wireless carriers.

Consumer high-speed Internet: As a result of our already high penetration of 70 percent of primary residential lines, we gained approximately 6,000 consumer high-speed Internet customers during the third quarter of 2012. We expect the pace of high-speed Internet customer growth to continue to slow as the number of households without high-speed Internet service shrinks and our penetration continues to increase. However, we believe growing customer demand for faster speeds and value-added services, such as online security and back-up, will drive growth in consumer high-speed Internet revenues. As of September 30, 2012, we could deliver speeds of 3 Megabits per second ("Mbps") to approximately 97 percent of our addressable lines, and speeds of 6 Mbps, 12 Mbps and 24 Mbps are available to approximately 73 percent, 47 percent and 13 percent of our addressable lines, respectively.

Consumer access line losses: Voice and switched access revenues will continue to be adversely impacted by future declines in access lines due to competition from cable television companies, wireless carriers and providers using other emerging technologies. To combat competitive pressures, we continue to emphasize our bundled products and services. Our consumers can bundle voice, high-speed Internet and video services, providing one convenient billing solution and bundle discounts. We believe that product bundles positively impact customer retention, and the associated discounts provide our customers the best value for their communications and entertainment needs. As of September 30, 2012, all of our access lines had wireless competition and approximately 69 percent of our access lines had fixed-line voice competition. Consumer lines decreased 87,000, or 4.4 percent during the twelve month period ended September 30, 2012, primarily due to the effects of competition.

44-------------------------------------------------------------------------------- Table of Contents Synergies and operational efficiencies: We continually strive to identify opportunities for operational efficiencies, in the context of both our acquired businesses and legacy operations. During the three and nine month periods ended September 30, 2012, we recognized approximately $45.0 million and $123.0 million in synergies from our acquisitions completed since the beginning of 2010, respectively, primarily related to workforce and network efficiencies. In addition to acquisition-related synergies, we also evaluate our legacy operations for operational efficiency. On May 31, 2012, we announced the review of our management structure to increase the efficiency of decision-making, to ensure our management structure is as simple and as responsive to customers as possible and position ourselves for continued success. We eliminated approximately 350 management positions as part of the restructuring, which was completed in the third quarter of 2012 and resulted in severance related costs of $22.4 million. The changes are expected to result in annualized savings of approximately $40.0 million.

45-------------------------------------------------------------------------------- Table of Contents ORGANIZATION AND RESULTS OF OPERATIONS We provide a wide range of telecom services, from advanced data solutions for businesses to basic consumer voice services. We deliver these services over owned or leased network facilities. Our sales, marketing and customer support teams are structured based upon the type of customer they serve. Our corporate support teams, such as finance and accounting, human resources and legal, support our operations as a whole. See below a detailed discussion and analysis of revenues and sales in our discussion of consolidated operating results.

The following table reflects our consolidated operating results as of September 30: Three Months Ended Nine Months Ended September 30, September 30, (Millions) (a) (b) (c) 2012 2011 2012 2011 Revenues and sales: Service revenues: Business $ 906.4 $ 491.8 $ 2,694.8 $ 1,468.0 Consumer 335.4 344.9 1,010.0 1,038.7 Wholesale 219.8 147.6 658.9 452.8 Other 26.1 10.3 82.4 33.3 Total service revenues 1,487.7 994.6 4,446.1 2,992.8 Product sales 64.7 28.6 189.3 83.1 Total revenues and sales 1,552.4 1,023.2 4,635.4 3,075.9 Costs and expenses: Cost of services (exclusive of depreciation and amortization included below) 671.3 366.3 1,987.3 1,101.5 Cost of products sold 56.8 24.5 159.3 68.6 Selling, general, and administrative 225.4 130.9 713.4 397.8 Depreciation and amortization 326.4 203.8 958.5 605.8 Merger and integration costs 12.7 19.9 54.4 33.9 Restructuring charges 12.1 0.5 23.3 0.7 Total costs and expenses 1,304.7 745.9 3,896.2 2,208.3 Operating income 247.7 277.3 739.2 867.6 Other (expense) income, net (5.3 ) (1.5 ) 4.6 (2.1 ) (Loss) gain on early extinguishment of debt - (20.5 ) 1.9 (124.4 ) Interest expense (155.4 ) (134.2 ) (465.4 ) (417.1 ) Income from continuing operations before income taxes 87.0 121.1 280.3 324.0 Income taxes 33.3 43.0 107.1 119.8 Income from continuing operations 53.7 78.1 173.2 204.2 Discontinued operations, net of tax - - (0.7 ) - Net income $ 53.7 $ 78.1 $ 172.5 $ 204.2 Operating Metrics: (Thousands) Business Operating Metrics: Customers Enterprise 174.8 65.8 Small business 471.9 397.0 Total customers (d) 646.7 462.8 Carrier special access circuits 112.7 106.4 Consumer Operating Metrics: Voice lines 1,865.2 1,951.7 High-speed Internet 1,216.2 1,199.5 Digital television customers 442.7 444.8 Total consumer connections 3,524.1 3,596.0 46 -------------------------------------------------------------------------------- Table of Contents (a) Results from operations include post-acquisition results from the former PAETEC operations. In the discussion and analysis provided below regarding changes in consolidated revenues and expenses in 2012, the impact of this acquisition on these changes is considered to be the revenues and expenses recognized during the period of each year for which results from the acquired operations are not included in the comparative period of the prior year.

(b) Effective during the fourth quarter of 2011, we changed our method of recognizing actuarial gains and losses for pension benefits. We have retrospectively adjusted financial information for prior periods presented to reflect our voluntary change in accounting principle for pension benefits. We elected to revise historical results for certain previously unrecorded immaterial errors. We concluded that the effects, individually and in the aggregate, are immaterial to the unaudited quarterly financial information. See Notes 2 and 8 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011.

(c) Certain prior year amounts have been reclassified to conform to the current year financial statement presentation. These reclassifications did not impact net or comprehensive income.

(d) Total customers include each individual business customer location to which we provide service and exclude carrier special access circuits.

Business Service Revenues Business service revenues include revenues from integrated voice and data services, advanced data and traditional voice and long-distance services to enterprise and small-business customers. Revenues from other carriers for special access circuits and fiber connections are also included. We expect business service revenues to be favorably impacted by increasing demand for data services such as integrated data and voice services, multi-site networking and data center services. As wireless data usage grows and fourth generation ("4G") networks are expanded, we expect to win additional opportunities to provide fiber and special access services to support the capacity needs of wireless carriers.

We experience competition in the business channel primarily from other carriers, including traditional telephone companies and alternative providers. Cable television companies are also a source of competition, primarily for small business customers and wireless backhaul contracts but have communicated their intention to compete for larger customers by expanding their product and sales capabilities.

For the twelve months ended September 30, 2012, business customers increased by approximately 183,900, or 39.7 percent, primarily due to the acquisition of PAETEC. Excluding PAETEC, business customers decreased by approximately 11,700, or 2.5 percent percent during the same period. During the third quarter of 2012, our business customers decreased by 4,600. Our growth in enterprise customers is slightly outpaced by losses in small business customers, typically due to competition from cable companies. However, our enterprise customers are driving growth in overall revenue through purchases of integrated voice and data services, data center and managed services, and advanced data services such as multi-site networking.

Despite the opportunities for growth from business services, competition and weakness in the economy may have the effect of suppressing revenue growth. In addition, traditional business voice and long-distance service revenues continue to decline due to competition and migration to more advanced integrated voice and data services.

The following table reflects the primary drivers of year-over-year changes in business service revenues: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC $ 396.5 $ 1,180.3 Due to increases in data and integrated services revenues (a) 10.5 28.8 Due to increases in carrier revenues (b) 3.6 14.8 Due to increases in data center and managed services revenues (c) 3.3 10.3 Due to increases in high-speed Internet revenues 0.8 3.7 Due to decreases in traditional voice, long distance and miscellaneous revenues (d) (0.1 ) (11.1 ) Total increases in business revenues $ 414.6 84 % $ 1,226.8 84 % 47 -------------------------------------------------------------------------------- Table of Contents (a) Increases in data and integrated services revenues were primarily due to demand for advanced data services and customer migration to our integrated voice and data services, previously discussed.

(b) Increases in carrier revenues, which primarily represent monthly recurring charges for dedicated circuits, were attributable to demand from wireless and other carriers, previously discussed.

(c) Increases in data center and managed services revenues, which primarily represent data center and colocation revenues, were due to increased demand and incremental sales.

(d) Decreases in traditional voice service revenues were primarily attributable to competition and migration of existing customers to integrated services and bundled offerings. These declines were partially offset by $4.1 million due to the implementation of the access recovery charge ("ARC"), which is a monthly charge established by the FCC designed to mitigate revenue reductions resulting from intercarrier compensation reform implemented in the third quarter of 2012.

Consumer Service Revenues Consumer service revenues are generated from the provision of high-speed Internet, voice and video services to consumers.

We expect the trend of consumer voice line loss to continue as a result of competition from wireless carriers, cable television companies and other providers using emerging technologies. For the twelve months ended September 30, 2012, consumer voice lines decreased by approximately 87,000, or 4.4 percent.

Increasing revenues from high-speed Internet and related services help to offset some of the losses in consumer voice revenues. Demand for faster broadband speeds and Internet-related services, such as virus protection and online data backup services, are expected to favorably impact consumer high-speed Internet revenues, offsetting some of the decline in consumer voice revenues.

For the twelve months ended September 30, 2012, consumer high-speed Internet customers increased by approximately 17,000, or 1.4 percent. During the third quarter of 2012, our consumer high-speed Internet customers increased by approximately 6,000. As of September 30, 2012, we provided high-speed Internet service to approximately 41 percent of total access lines in service and approximately 70 percent of primary residential lines in service. As of September 30, 2012, approximately 76 percent of our total access lines had high-speed Internet competition, primarily from cable service providers. We do not expect significant additional cable expansions into our service areas during 2012, but we could experience some increased competition from high-speed Internet offerings of wireless competitors. We expect the pace of high-speed Internet customer growth to continue to slow as the number of households without high-speed Internet service shrinks and our penetration continues to increase.

To combat competitive pressures in our markets, we continue to emphasize our bundle service strategy and enhance our network to offer faster Internet speeds.

Service bundles provide discounts and other incentives for customers to bundle their voice, long distance, high-speed Internet and video services and have positively impacted our operating trends.

The following table reflects the primary drivers of year-over-year changes in consumer service revenues: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to increases in high-speed Internet revenues (a) 4.3 14.8 Due to decreases in voice, long distance and miscellaneous revenues (b) (13.8 ) (43.5 ) Total decreases in consumer revenues $ (9.5 ) (3 )% $ (28.7 ) (3 )% (a) Increases in high-speed Internet revenues were primarily due to the increase in high-speed Internet customers, continued migration to higher speeds and increased sales of value added services, as previously discussed.

(b) Decreases in voice service revenues were primarily attributable to declines in voice lines.

48 -------------------------------------------------------------------------------- Table of Contents Wholesale Service Revenues Wholesale service revenues include switched access revenues, Universal Service Fund ("USF") revenues and voice and data services sold on a wholesale basis.

Switched access revenues include usage sensitive revenues from long distance companies and other carriers for access to our network in connection with the completion of long distance calls, as well as reciprocal compensation received from wireless and other local connecting carriers for the use of our facilities.

USF revenues are government subsidies, collected from our customers, designed to partially offset the cost of providing wireline services in high-cost areas. In addition, we offer our voice and data services on a wholesale basis to other carriers.

Revenues from these services are expected to decline due to access line losses and reductions in switched access rates.

The following table reflects the primary drivers of year-over-year changes in wholesale service revenues: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC (a) $ 92.5 $ 252.0 Due to increases in federal USF revenues (b) 12.3 14.7 Due to decreases in voice and other revenues (0.4 ) (1.6 ) Due to decreases in state USF revenues (1.0 ) (2.1 ) Due to decreases in switched access revenues (c) (31.2 ) (56.9 ) Total increases in wholesale revenues $ 72.2 49 % $ 206.1 46 % (a) During the first quarter of 2012, we suspended and modified certain PAETEC wholesale products, which represented approximately $16.0 million in revenue recognized during the nine months ended September 30, 2012.

(b) Increases in federal USF revenues were primarily due to the implementation of the access recovery mechanism ("ARM") during the third quarter of 2012. The ARM is additional federal universal service support available to help mitigate revenue losses from intercarrier compensation reform not covered by the ARC, previously discussed. In addition, Federal USF revenues increased due to a change in the contribution factor from 14.4 percent to 15.7 percent, resulting in a proportionate change in federal USF expense included in cost of services below.

(c) Decreases in switched access revenues were primarily due to the impact of intercarrier compensation reform and continued declines in voice lines.

The ARC and ARM, discussed previously, are designed to help mitigate the revenue losses resulting from intercarrier compensation reform.

Other Service Revenues Other service revenues include revenues from certain consumer markets where we lease the connection to the customer premise, software and other miscellaneous services. In the consumer markets where we lease the connection to the customer premise, we are no longer offering new service. As a result of this decision, we expect other service revenues to decline as current customers disconnect.

The following table reflects the primary drivers of year-over-year changes in other service revenues: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC $ 17.5 $ 55.9 Due to decreases in other (1.7 ) (6.8 )Total increases in other revenues $ 15.8 153 % $ 49.1 147 % 49 -------------------------------------------------------------------------------- Table of Contents Product Sales Product sales include data and communications equipment sold to businesses and high-speed Internet modems, home networking equipment, computers and other equipment sold to consumers. In addition, we sell network equipment to contractors on a wholesale basis.

The following table reflects the primary drivers of year-over-year changes in product sales: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC $ 33.3 $ 89.1 Due to increases in contractor sales (a) 3.3 16.2 Due to increases in consumer product sales (b) 0.2 1.4 Due to decreases in business product sales (0.7 ) (0.5 ) Total increases in product sales $ 36.1 126 % $ 106.2 128 % (a) Increases in contractor sales were primarily due to increased sales of outside plant materials.

(b) Increases of consumer product sales were driven by increased sales for home networking and customer premise equipment.

Cost of Services Cost of services expenses primarily consist of network operations costs, including salaries and wages, employee benefits, materials, contract services and information technology costs to support the network. Cost of services expenses also include interconnection expense, which are costs incurred to access the public switched network and transport traffic to the Internet, bad debt expense and business taxes. Interconnection expenses include charges to lease network components required for service delivery in markets where we do not own the primary network infrastructure.

The following table reflects the primary drivers of year-over-year changes in cost of services: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC $ 287.5 $ 856.9 Due to increases in third-party costs for ancillary voice and data services (a) 3.4 12.5 Due to increases in interconnection expense (b) 0.6 11.4 Due to increases in federal USF expenses (c) 0.2 3.4 Due to increases in network operations and other (d) 2.4 3.0 Due to changes in postretirement and pension expense (e) 10.9 (1.4 ) Total increases in cost of services $ 305.0 83 % $ 885.8 80 % (a) Increases in third-party costs were due to increases in charges incurred to provide third-party services to customers and charges incurred to provide voice features and value added data services to customers.

(b) Increases in interconnection expense were attributable to increased purchases of circuits, including circuits to service the growth in data customers, as well as higher capacity circuits to service existing customers and increase the transport capacity of our network, partially offset by the favorable impact of network efficiency projects and rate reductions.

(c) Increases in federal USF contributions were driven by an increase in the USF contribution factors from 14.4 percent and 15.7 percent for the nine month periods ended September 30, 2011 and 2012, respectively. A proportionate increase is seen in federal USF surcharge revenues.

50 -------------------------------------------------------------------------------- Table of Contents (d) Increases in network operations and other expenses were due to higher leased network facilities costs, offset by incremental internal labor charged to capital projects as a result of increased capital spend and activity.

(e) Increases in postretirement and pension expense for the three months ended September 30, 2012, are primarily driven by a curtailment gain recognized during the third quarter of 2011 as a result of the elimination of basic retiree life insurance coverage for certain current and future retirees.

For the nine months ended September 30, 2012, this was offset by a curtailment gain recognized during the second quarter of 2012 related to the elimination of all benefits for certain current and future retirees.

Cost of Products Sold Cost of products sold represents the cost of equipment sales to customers.

The following table reflects the primary drivers of year-over-year changes in cost of products sold: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC $ 29.6 $ 74.4 Due to increases in costs of contractor sales (a) 3.5 16.5 Due to changes in equipment sales to business customers (0.4 ) 0.2 Due to decreases in consumer costs of product sold (b) (0.4 ) (0.4 ) Total increases in cost of products sold $ 32.3 132 % $ 90.7 132 % (a) Increases in contractor cost of products sold were consistent with the changes in contractor sales.

(b) Decreases in consumer costs of products sold were driven by the decrease in sales, driven by lower customer broadband additions as compared to the same period in the prior year.

Selling, General and Administrative ("SG&A") SG&A expenses result from sales and marketing efforts, advertising, information technology support systems, costs associated with corporate and other support functions and professional fees. These expenses also include salaries and wages and employee benefits not directly associated with the provision of services.

The following table reflects the primary drivers of year-over-year changes in SG&A expenses: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to acquisition of PAETEC $ 106.4 $ 329.3 Due to increases in medical insurance expenses (a) 4.6 14.8 Due to changes in pension and postretirement expenses (b) 3.3 (0.4 ) Due to decreases in other costs (c) (11.5 ) (6.4 ) Due to decreases in sales and marketing expenses (d) (8.3 ) (21.7 ) Total increases in SG&A and other expenses $ 94.5 72 % $ 315.6 79 % (a) Increases in medical insurance expenses were primarily due to increases in medical claims and related costs.

(b) Increases in postretirement and pension expense for the three months ended September 30, 2012, are primarily driven by a curtailment gain recognized during the third quarter of 2011 as a result of the elimination of basic retiree life insurance coverage for certain current and future retirees.

For the nine months ended September 30, 2012, this was offset by a curtailment gain recognized during the second quarter of 2012 related to the elimination of all benefits for certain current and future retirees.

51 -------------------------------------------------------------------------------- Table of Contents (c) Decreases in other costs were primarily due to losses related to litigation activity recorded in 2011 and various other costs in 2012.

(d) Decreases in sales and marketing expenses were due to lower compensation costs for the business channel and decreased advertising expenses.

Depreciation and Amortization Expense Depreciation and amortization expense includes the depreciation of our plant assets and the amortization of our intangible assets.

The following table reflects the primary drivers of year-over-year changes in depreciation and amortization expense: Three Months Ended Nine Months Ended September 30, 2012 September 30, 2012 Increase Increase (Millions) (Decrease) % (Decrease) % Due to depreciation of PAETEC's plant assets $ 53.5 $ 143.9 Due to amortization of intangible assets acquired from PAETEC 41.0 122.3 Due to increases in depreciation expense (a) 33.9 106.4 Due to decreases in amortization expense (b) (5.8 ) (19.9 ) Total increases in depreciation and amortization expense $ 122.6 60 % $ 352.7 58 % (a) Increases in depreciation expense were primarily due to additions in property, plant and equipment. Additionally, we implemented new depreciation rates beginning in 2012 for certain subsidiaries, which resulted in a net increase to depreciation expense of $44.7 million for the nine month period ended September 30, 2012. See Note 2 to the consolidated financial statements.

(b) Decreases in amortization expense were due to the use of accelerated amortization methods.

Merger, Integration and Restructuring Costs We incur a significant amount of costs to complete a merger or acquisition and integrate its operations into our business. These costs are presented as merger and integration expense in our results of operations and include transaction costs such as banker and legal fees, employee-related costs such as severance, system conversion and rebranding costs. Our recent acquisitions of PAETEC, NuVox Inc., Iowa Telecom, Q-Comm and Hosted Solutions drive merger and integration costs for the periods presented.

Restructuring charges are sometimes incurred as a result of evaluations of our operating structure. Among other things, these evaluations explore opportunities for task automation, network efficiency and the balancing of our workforce based on the current needs of our customers. Severance, lease exit costs and other related charges are included in restructuring charges.

On May 31, 2012, we announced the review of our management structure to increase the efficiency of decision-making, to ensure our management structure is as simple and as responsive to customers as possible and position ourselves for continued success. We eliminated approximately 350 management positions as part of the restructuring, which was completed in the third quarter of 2012 and resulted in severance related costs of $22.4 million. The changes are expected to result in annualized savings of approximately $40.0 million. Severance, lease exit costs and other related charges are included in restructuring charges.

Merger, integration and restructuring costs are unpredictable by nature but should not necessarily be viewed as non-recurring.

52-------------------------------------------------------------------------------- Table of Contents Set forth below is a summary of merger, integration and restructuring costs for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2012 2011 2012 2011 Merger and integration costs: Transaction costs associated with acquisitions (a) $ - $ 17.8 $ 7.1 $ 21.1 Employee related transition costs (b) 3.1 1.0 17.4 7.9 Computer system and conversion costs 1.9 0.9 5.3 4.3 Signage, rebranding and other costs (c) 7.7 0.2 24.6 0.6 Total merger and integration costs 12.7 19.9 54.4 33.9 Restructuring charges (d) 12.1 0.5 23.3 0.7 Total merger, integration and restructuring charges $ 24.8 $ 20.4 $ 77.7 $ 34.6 (a) Transaction costs incurred during the three and nine months ended September 30, 2012, primarily relate to accounting, legal, broker fees and other miscellaneous costs associated with the acquisition of PAETEC. These costs are considered indirect or general and are expensed when incurred.

During the three and nine months ended September 30, 2011, we incurred acquisition-related costs for accounting, legal, broker fees and other miscellaneous costs associated with the acquisitions of NuVox, Iowa Telecom, Q-Comm, Hosted Solutions and PAETEC. These costs are considered indirect or general and are expensed when incurred.

(b) Employee related transition costs during 2012 primarily consists of severance related to the integration of PAETEC.

(c) Signage, rebranding and other costs includes signage, rebranding, lease termination, consulting fees associated with integration activities and other integration related expenses.

(d) Restructuring charges primarily related to the restructuring announcement made on May 31, 2012. See previous discussion.

Summary of Liability Activity Related to Both Merger and Integration Costs and Restructuring Charges As of September 30, 2012, we had unpaid merger, integration and restructuring liabilities totaling $22.2 million, which consisted of $4.8 million of accrued severance costs primarily associated with the integration of PAETEC, $6.7 million primarily associated with the restructuring announcement made on May 31, 2012, and $10.7 million related to other integration activities. Severance and related employee costs are included in other current liabilities in the the accompanying unaudited interim consolidated balance sheet and will be paid as positions are eliminated, excluding salary continuation payments. These payments will be funded through operating cash flows (see Note 9).

Operating Income Operating income decreased $29.6 million, or 10.7 percent and $128.4 million, or 14.8 percent, during the three and nine month periods ended September 30, 2012, respectively, as compared to the same period in 2011. The decrease for the three month period ended September 30, 2012, as compared to the same period in 2011, was primarily due to an increase in depreciation and amortization expense, driven by changes in depreciable lives and increased capital expenditures, as previously discussed.

The decrease for the nine month period ended September 30, 2012, as compared to the same period in 2011 was primarily due to an increase in depreciation and amortization expense, driven primarily by changes in depreciable lives and increased capital expenditures as previously discussed. Also contributing to the decrease in operating income were increases in merger, integration and restructuring expense as a result of the integration of PAETEC and our management reorganization previously discussed. These increases in expense were partially offset by operating income generated from PAETEC of $19.3 million and expense management initiatives.

53-------------------------------------------------------------------------------- Table of Contents Operating Income before Depreciation and Amortization ("OIBDA") OIBDA increased $93.0 million, or 19.3 percent and $224.3 million, or 15.2 percent, for the three and nine month periods ended September 30, 2012, respectively, as compared to the same period in 2011 (see "Reconciliation of non-GAAP Financial Measures"). The increases for the three and nine month periods ended September 30, 2012, were primarily due to OIBDA from PAETEC of $86.7 million and $285.5 million, respectively. The increase in OIBDA from PAETEC for the nine month period ended September 30, 2012, was partially offset by an increase in merger, integration and restructuring charges, discussed above.

Other (Expense) Income, Net Set forth below is a summary of other income, net for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2012 2011 2012 2011 Interest income $ - $ - $ 1.0 $ 1.5 (Loss) gain on sale of investments (a) (0.2 ) - 7.2 0.9 Other income, net (0.2 ) - 3.9 0.5 Ineffectiveness of interest rate swaps (4.9 ) (1.5 ) (7.5 ) (5.0 ) Other (expense) income, net $ (5.3 ) $ (1.5 ) $ 4.6 $ (2.1 ) (a) This increase for the nine month period ended September 30, 2012, was primarily due to the sale of wireless assets associated with Iowa Telecom and D&E Communications, Inc. ("D&E"). See Note 2 to the consolidated financial statements.

Loss (Gain) on Extinguishment of Debt During the first quarter of 2012, we retired all $300.0 million of the outstanding 9.500 percent notes due July 15, 2015 ("PAETEC 2015 Notes"). The PAETEC 2015 Notes were purchased using borrowings on our revolving line of credit. The retirements were accounted for under the extinguishment method, and as a result we recognized a gain on extinguishment of debt of $1.9 million during the nine month period ended September 30, 2012.

During the nine month period ended September 30, 2011, we repurchased $1,544.5 million of our 2016 8.625 percent Senior Notes ("2016 Notes") and all $400.0 million of our 7.750 percent Valor Notes ("Valor Notes"). We financed these transactions with proceeds from various debt offerings and borrowings from our revolving line of credit. These transactions allowed us to extend our existing debt maturities and lower our interest rates. The retirements were accounted for under the extinguishment method, and as a result we recognized a loss on extinguishment of debt of $124.4 million during the first quarter of 2011.

54-------------------------------------------------------------------------------- Table of Contents The loss (gain) on extinguishment of debt is shown as follows for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2012 2011 2012 2011 2015 PAETEC Notes: Premium on early redemption $ - $ - $ 14.3 $ - Unamortized premium on original issuance - - (16.2 ) - Gain on early extinguishment for 2015 PAETEC Notes - - (1.9 ) - 2016 Notes: Premium on early redemption - 15.2 - 92.7 Unamortized discount on original issuance - 5.1 - 23.7 Third-party fees for early redemption - - - 2.7 Unamortized debt issuance costs on original issuance - 0.2 - 1.1 Loss on early extinguishment for 2016 Notes - 20.5 - 120.2 Valor Notes: Premium on early redemption - - - 10.3 Third-party fees for early redemption - - - 0.4 Unamortized premium on original issuance - - - (6.5 ) Loss on early extinguishment for Valor Notes - - - 4.2 Total loss (gain) on early extinguishment of debt $ - $ 20.5 $ (1.9 ) $ 124.4 Interest Expense Set forth below is a summary of interest expense for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2012 2011 2012 2011 Senior secured credit facility, Tranche A $ 4.1 $ 1.3 $ 9.0 $ 4.8 Senior secured credit facility, Tranche B 14.2 10.1 35.2 30.0 Senior secured credit facility, revolving line of credit 3.7 5.2 15.8 13.1 Senior unsecured notes 100.2 101.6 300.5 314.4 Notes issued by subsidiaries 22.7 2.2 69.2 10.1 Impacts of interest rate swaps 13.3 16.2 41.1 49.5 Interest on capital leases and other 0.7 - 2.5 0.2 Less capitalized interest expense (3.5 ) (2.4 ) (7.9 ) (5.0 ) Total interest expense $ 155.4 $ 134.2 $ 465.4 $ 417.1 Interest expense increased $21.2 million, or 15.8 percent and $48.3 million, or 11.6 percent for the three and nine month periods ended September 30, 2012, as compared to the same period of 2011, respectively. The increase in 2012 was primarily due to interest incurred on notes issued by subsidiaries, specifically PAETEC.

Income Taxes Income tax expense decreased $9.7 million, or 22.6 percent and $12.7 million, or 10.6 percent for the three and nine month periods ended September 30, 2012, as compared to the same periods in 2011, respectively. The decrease in income tax expense in 2012 is primarily due to the decrease in income before taxes. Our effective tax rate increased to 38.3 percent and 38.2 percent for the three and nine month periods ended September 30, 2012, as compared to 35.5 percent and 37.0 percent in the corresponding periods in 2011.

55-------------------------------------------------------------------------------- Table of Contents For 2012, our annualized effective income tax rate is expected to range between 38.0 percent and 39.0 percent, excluding one-time discrete items. Changes in our relative profitability, as well as recent and proposed changes to federal and state tax laws may cause the rate to change from historical rates. In determining our quarterly provision for income taxes, we use an estimated annual effective tax rate, which is based on our expected annual income, statutory rates and tax planning opportunities. Significant or unusual items are separately recognized in the quarter in which they occur.

Discontinued Operations, Net of Tax On November 30, 2011, we completed the acquisition of PAETEC. The operating results of the energy business acquired as part of PAETEC, which sells electricity to business and residential customers, primarily in certain geographic regions in New York state, as a competitive supplier, have been separately presented as discontinued operations in the accompanying consolidated statements of income. On June 15, 2012, we completed the sale of the energy business. See Note 14 for additional information.

Pension Expense In accordance with our accounting policy for pension benefits, we recognize actuarial gains and losses in our operating results in the year in which the gains or losses occur. We will remeasure our pension assets and liabilities based on updated actuarial assumptions at December 31, 2012, including the actual return on plan assets during the year and the current discount rate. We expect to take a significant charge during the fourth quarter of 2012, primarily due to a decline in the discount rate.

As of June 30, 2012, a decline in the discount rate of 25 basis points would have resulted in an increase in pension expense of $37.4 million. As of September 30, 2012, our discount rate had declined approximately 90 basis points as compared to the prior plan measurement. We have also experienced year to date gains in our pension plan assets through September 30, 2012, of 11.6 percent, as compared to projected gains of 8.0 percent. Each increase (decrease) of 50 basis points as compared to the projected gains would result in a gain (loss) of $4.6 million upon remeasurement.

Our discount rate and return on plan assets are primarily driven by changes in interest rates and the performance of the financial markets, both of which could change significantly prior to the plan remeasurement. As such, we are not able to determine or project the actual amount of the expected charge that we may record in the fourth quarter at this time.

Regulatory Matters We are subject to regulatory oversight by the Federal Communications Commission ("FCC") for particular interstate matters and state public utility commissions ("PUCs") for certain intrastate matters. We are also subject to various federal and state statutes that direct such regulations. We actively monitor and participate in proceedings at the FCC and PUCs and engage federal and state legislatures on matters of importance to us.

Federal Regulation and Legislation Intercarrier Compensation and USF Reform On November 18, 2011, the FCC released an order ("the Order") which established a framework for reform of the intercarrier compensation system and the federal Universal Service Fund ("USF"). The Order had two major provisions: • the elimination of terminating switched access rates and other per-minute terminating charges between service providers by 2018, through annual reductions in the rates, and • the provision of USF support for voice and broadband services.

In reforming the USF, the Order established the Connect America Fund, which included a short-term ("CAF Phase 1") and a longer-term ("CAF Phase 2") framework. CAF Phase 1 provides for continued legacy USF funding frozen at 2011 levels as well as the opportunity for incremental broadband funding to a number of unserved locations, limited to $775 per unserved location. As a result of our aggressive broadband deployment to date, we have very few unserved locations remaining in our service areas for which $775 in incremental support would make broadband deployment economical. On July 24, 2012, we elected to accept approximately $0.7 million of the $60.4 million in incremental support allocated to us for 2012. In addition, we filed a waiver request seeking to modify certain CAF Phase 1 requirements, which would enable us to accept the remaining $59.7 million to expand our broadband footprint. The waiver request is still pending.

56 -------------------------------------------------------------------------------- Table of Contents The FCC is working to establish rules for CAF Phase 2 funding based on a forward-looking cost model to further extend broadband to high-cost areas. The development of this model is ongoing and is not expected to be completed by the end of 2012 as originally scheduled by the FCC. Until the implementation of CAF Phase 2 is complete, our annual USF funding will continue to be frozen at 2011 levels, but we will be required to use one-third of the frozen legacy support to operate and build broadband networks beginning in 2013. In 2014, this condition will apply to two-thirds of the frozen legacy support, and in 2015 it will increase to 100 percent. Based on current expenditures, we expect to comply with these additional funding conditions for all periods. In addition, if the FCC does not implement CAF Phase 2 by the end of 2012, the FCC may continue to provide CAF Phase 1 incremental support in 2013.

As part of the Order's reform of intercarrier compensation, the FCC established two recovery mechanisms that mitigate the revenue reductions resulting from the reductions and ultimate elimination of terminating access rates. First, the FCC established the access recovery charge ("ARC"), a fee which may be assessed to our retail customers. Second, the access recovery mechanism ("ARM") is a form of additional federal universal service support designed to allow carriers to recover revenue reductions not recovered from the assessment of the ARC.

On April 25, 2012, the FCC decided that originating access rates for intrastate long distance traffic exchanged between an Internet-protocol network and the traditional telecommunications network should be subject to default rates equal to interstate originating access rates beginning on July 1, 2014. The FCC refused at that time to adopt a mechanism that would allow companies to recover the loss of originating access revenues resulting from the change. On July 27, 2012, we filed a petition for review with the U.S. Court of Appeals of the District of Columbia seeking relief from the April 2012 ruling on the grounds that it is arbitrary, capricious, in excess of the FCC's statutory authority and otherwise not in accordance with law. That petition for review was transferred to the U.S. Court of Appeals for the 10th Circuit on August 28, 2012, and on October 1, 2012, our appeal was consolidated with 30 appeals on the Order. Our initial brief is due on December 10, 2012, and briefing is expected to be completed in the second quarter of 2013. We continue to assess the impacts of the FCC's intercarrier compensation reform on our wholesale business activities.

Additional implications of the Order will likely result in future additional rulemaking and require significant interpretation, management judgment and collaboration with other telecommunications carriers. As a result of these factors, we expect numerous disputes with other carriers with respect to the proper amount of intercarrier compensation that is payable between such parties, and these disputes can sometimes become significant. Our policy is to establish reserves on wholesale revenues and accounts receivable balances when collectability is not reasonably assured. We do not believe that ultimate resolution of uncertainties, including asserted and unasserted disputes and claims from other telecommunications carriers, relate to wholesale services provided to date will have a material impact on the future consolidated results of operations, cash flows or our financial condition.

We believe the steps we have taken to diversify our revenue streams and focus on growth opportunities will help us navigate through this transition without significant adverse effects. Given the ongoing transformation of our business towards business and enterprise, coupled with the positive impact of the ARC and the additional universal service support available from the ARM, we do not believe the Order's reform of intercarrier compensation will have a material impact on our results of operation, cash flows or our financial condition.

Set forth below is a summary of intercarrier compensation revenue, reciprocal compensation expense and federal universal service support for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended (Millions) 2012 2011 2012 2011 Intercarrier compensation revenue $ 84.0 $ 72.2 $ 267.1 $ 220.6 Reciprocal compensation expense $ 36.6 $ 29.6 $ 135.5 $ 58.2 Federal universal service support $ 36.3 $ 24.5 $ 86.5 $ 74.8 Broadband Stimulus As part of the American Recovery and Reinvestment Act of 2009 ("ARRA"), approximately $7.2 billion was allocated for the purpose of expanding broadband services to unserved and underserved areas. The Rural Utilities Service ("RUS"), part of the United States Department of Agriculture, approved eighteen of our applications for these funds for projects totaling $241.7 million. The RUS will fund 75 percent of these approved grants, or $181.3 million, and we will fund 25 percent, or $60.4 million.

57 -------------------------------------------------------------------------------- Table of Contents Selected information related to the broadband stimulus expenditures and receipts is as follows for the three and nine month periods ended September 30: Three Months Ended Nine Months Ended Inception to (Millions) 2012 2011 2012 2011 Date Stimulus capital expenditures funded by RUS $ 31.0 $ 7.2 $ 68.8 $ 9.2 $ 91.5 Stimulus capital expenditures funded by Windstream (a) 15.8 2.4 28.4 3.1 36.4 Total stimulus capital expenditures $ 46.8 $ 9.6 $ 97.2 $ 12.3 $ 127.9 Funds received from RUS $ 6.9 $ 0.5 $ 26.5 $ 0.5 $ 30.5 (a) Stimulus capital expenditures funded by Windstream are included in our capital expenditure totals for each period presented in the statements of cash flows. This figure includes certain non-reimburseable charges for which we are responsible for the full amount of the cost.

State Regulation and Legislation State Universal Service We recognize revenue from the receipt of state universal service funding in a limited number of states in which we operate. For the nine month period ended September 30, 2012, we recognized $94.9 million in state USF revenue, which included approximately $66.7 million from the Texas USF. These payments are intended to provide additional support, beyond the federal USF receipts, for the high cost of operating in certain rural markets.

Several states, including Texas and Pennsylvania, are currently conducting reviews of their universal service funds and intercarrier compensation systems.

The Texas PUC recently adopted an order which we expect to reduce our Texas USF support by approximately $4.3 million each year over the next four years. The Texas PUC is considering further needs-based and rate rebalancing reforms which could adversely impact our support in the future. We are not yet able to determine the financial impact of additional Texas USF reform or reform in other states. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of Part II of our Annual Report on Form 10-K for the year ended December 31, 2011, filed with the SEC on February 22, 2012, for more information regarding our state regulatory matters.

58-------------------------------------------------------------------------------- Table of Contents FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Liquidity and Capital Resources We rely largely on operating cash flows and long-term debt to provide for our liquidity requirements. We expect cash flows from operations will be sufficient to fund ongoing working capital requirements, planned capital expenditures, scheduled debt principal and interest payments and dividend payments through 2012. Additionally, we have access to capital markets and available borrowing capacity under our revolving credit agreements.

Our cash position decreased by $112.2 million to $114.8 million at September 30, 2012, from $227.0 million at December 31, 2011, as compared to an increase of $8.0 million during the same period in 2011. Cash outflows were primarily driven by repayments of debt and payment of interest, capital expenditures and dividends. These outflows were partially offset by cash inflows from operations of $1,243.6 million and proceeds from debt issuances of $1,775.0 million.

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