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QWEST COMMUNICATIONS INTERNATIONAL INC - 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, references in this report to "Qwest,"
"we," "us" and "our" refer to Qwest Communications International Inc. and its
consolidated subsidiaries, references to "QCII" refer to Qwest Communications
International Inc. on an unconsolidated, stand-alone basis, references to
"CenturyLink" refer to our direct parent company, CenturyLink, Inc. and its
consolidated subsidiaries, and references to "QC" refer to Qwest Corporation,
our principal subsidiary.
All references to "Notes" in this Item 2 refer to the Notes to Consolidated
Financial Statements included in Item 1 of this quarterly report.
Certain statements in this report constitute forward-looking statements. See
"Risk Factors" in Item 1A of Part II of this report for a discussion of certain
factors that could cause our actual results to differ from our anticipated
results.
Overview
Management's Discussion and Analysis of Financial Condition and Results of
Operations ("MD&A") included herein should be read in conjunction with MD&A and
the other information included in our Annual Report on Form 10-K for the year
ended December 31, 2011. The results of operations for the first nine months of
the year are not indicative of the results of operations that might be expected
for the entire year.
We are an integrated communications company engaged primarily in providing
an array of communications services to our residential, business, governmental
and wholesale customers. Our communications services include local and
long-distance, network access, private line (including special access),
broadband, data, managed hosting, wireless and video services. In certain local
and regional markets, we also provide local access and fiber transport services
to competitive local exchange carriers. We strive to maintain our customer
relationships by, among other things, bundling our service offerings to provide
our customers with a complete offering of integrated communications services.
We generate the majority of our revenues from services provided in the
14-state region of Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska,
New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming. We
refer to this region as our local service area.
As discussed in Note 2-Acquisition by CenturyLink, on April 1, 2011, we
became a wholly owned subsidiary of CenturyLink in connection with a
stock-for-stock acquisition. The aggregate consideration was approximately
$12.273 billion, calculated in the manner described in Note 2-Acquisition by
CenturyLink.
Since April 1, 2011, our consolidated results of operations have been
included in the consolidated results of operations of CenturyLink. CenturyLink
has accounted for its acquisition of us under the acquisition method of
accounting, which resulted in the assignment of the purchase price to the assets
acquired and liabilities assumed based on estimates of their acquisition date
fair values. The aggregate consideration exceeded the aggregate estimated fair
value of the assets acquired and liabilities assumed by $10.123 billion, which
we have recognized as goodwill. This goodwill is attributable to strategic
benefits, including enhanced financial and operational scale, market
diversification and leveraged combined networks that we expect CenturyLink and
its consolidated subsidiaries, including us, to realize. None of the goodwill
associated with this acquisition is deductible for income tax purposes. The
recognition of assets and liabilities at fair value is reflected in our
consolidated financial statements and therefore has resulted in a new basis of
accounting for the "successor period" beginning on April 1, 2011. This new basis
of accounting means that our consolidated financial statements for the successor
periods will not be comparable to our previously reported consolidated financial
statements, including the predecessor period consolidated financial statements
in this report.
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We have accounted for CenturyLink's acquisition of us under the acquisition
method of accounting, which resulted in the assignment of the aggregate
consideration to the assets acquired and liabilities assumed based on their
acquisition date fair values. The fair value of the aggregate consideration
transferred exceeded the acquisition date fair value of the recorded tangible
and intangible assets, and assumed liabilities by $10.123 billion, which has
been recognized as goodwill. The impairment testing is done at the reporting
unit level; in reviewing the criteria for reporting units when allocating the
goodwill resulting from our acquisition by CenturyLink, it was determined that
we are one reportable unit. We are required to review goodwill recorded in
business combinations for impairment at least annually, or more frequently if
events or circumstances indicate there may be impairment. Our annual measurement
date for testing goodwill impairment is September 30. We are required to
write-down the value of goodwill only in periods in which the recorded amount of
goodwill exceeds the fair value.
The discussion in MD&A of our performance for the nine months ended
September 30, 2011 is presented on a combined basis for the predecessor and
successor periods in 2011. We believe this presentation allows the consolidated
results of operations for this period to be more readily compared to the
comparable nine-month period in 2012.
We have incurred operating expenses related to CenturyLink's acquisition of
us, which consist primarily of integration and severance expenses. The table
below summarizes our acquisition-related expenses:
Successor Predecessor Combined
Three Months Three Months Nine Months Six Months Three Months Nine Months
Ended Ended Ended Ended Ended Ended
September 30, September 30, September 30, September 30, March 31, September 30,
2012 2011 2012 2011 2011 2011
(Dollars in millions)
Acquisition-related
expenses $ 10 19 39 146 3 149
CenturyLink has cash management arrangements between certain of its
subsidiaries, including us, under which the majority of our cash balance is
transferred on a daily basis to CenturyLink. We report the balance of these
transfers on our consolidated balance sheet as advances to affiliates.
Since the April 1, 2011 closing of CenturyLink's acquisition of us, our
operations have been integrated into and reported as part of the segments of
CenturyLink. CenturyLink's chief operating decision maker ("CODM") has become
our CODM, but reviews our financial information on an aggregate basis only in
connection with our quarterly and annual reports that we file with the
Securities and Exchange Commission ("SEC"). Consequently, we do not provide our
discrete financial information to the CODM on a regular basis. As such, we now
have one reportable segment and we have reclassified our prior period results to
conform to our current view.
We currently categorize our products, services and revenues among the
following four categories:
º •
º Strategic services, which include primarily private line (including
special access), broadband, Multi-Protocol Label Switching ("MPLS")
(which is a data networking technology that can deliver the quality of
service required to support real-time voice and video), Ethernet,
hosting, video (including resold satellite video services), voice over
Internet Protocol ("VoIP") and Verizon Wireless services;
º •
º Legacy services, which include primarily local, long-distance,
integrated services digital network ("ISDN") (which uses regular
telephone lines to support voice, video and data applications),
switched access and traditional wide area network ("WAN") services
(which allows a local communications network to link to networks in
remote locations);
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º •
º Data integration, which includes the sale of telecommunications
equipment located on customers' premises and related professional services, such as network management, installation and maintenance of
data equipment and building of proprietary fiber-optic broadband
networks for our government and business customers; and
º • º Affiliates and other services, which consist primarily of universal
service funds ("USF") revenues and surcharges and services we provide
to our non-consolidated affiliates. We provide to our affiliates
telecommunications services that we also provide to external
customers. In addition, we provide to our affiliates computer system development and support services and network support and technical
services.
During the first quarter of 2012, we reclassified certain prior period
revenues between the aforementioned four categories to conform to the current
period presentation.
As of the successor date of September 30, 2012, we operated approximately
8.2 million access lines, which are telephone lines reaching from the customers'
premises to a connection with the public switched telephone network. We count
access lines when we install the service. Our methodology includes only those
access lines that we use to provide services to external customers and excludes
lines used solely by us and our affiliates. It also excludes unbundled loops and
includes stand-alone broadband subscribers. Our methodology for counting our
access lines may not be comparable to those of other companies. As of the
successor date of September 30, 2012, we also served approximately 3.3 million
broadband subscribers. As described below, during the second quarter of 2012, we
updated our methodology for counting broadband subscribers to include
residential, business and wholesale subscribers instead of only residential and
small business subscribers.
Our analysis presented below is organized to provide the information we
believe will be useful for understanding the relevant trends affecting our
business. This discussion should be read in conjunction with our consolidated
financial statements and the notes thereto in Item 1 of this report.
Business Trends
Our financial results were impacted by several significant trends, which are
described below. We expect that these trends will continue to affect our
consolidated results of operations, cash flows or financial position.
º •
º Strategic services. We continue to see shifts in the makeup of our
total revenues as customers move to strategic services, such as
private line, broadband and video services, from legacy services, such as local and access services. Revenues from our strategic services
represented 45% and 43% of our total revenues for the successor three
months ended September 30, 2012 and 2011, respectively, and 44% and
43% of our total revenues for the successor nine months ended
September 30, 2012 and the combined nine months ended September 30, 2011, respectively, and we expect that this percentage will continue
to grow. We continue to focus on increasing subscribers of our
broadband services, particularly among consumer and small business
customers. We believe that continually increasing connection speeds is
important to remaining competitive in our industry. As a result, we
continue to invest in our fiber to the node ("FTTN") deployment, which
allows for the delivery of higher speed broadband services than would
otherwise generally be available through a more traditional
telecommunications network made up of only copper wires. In addition
to our FTTN deployment, we continue to expand our product offerings,
including Ethernet and MPLS, and enhance our marketing efforts as we
compete in a maturing market in which most consumers already have
broadband services. While traditional broadband services are
declining, they have been more than offset by growth in fiber based
broadband services. We expect these efforts will improve our ability
to compete and increase our broadband revenues. Another trend
impacting our strategic services is the deployment of fiber-based
special access services provided to wireless carriers, which in many
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cases replaces existing copper-based special access services. We
believe the growth in fiber-based special access services provided to
wireless carriers for backhaul will, ultimately, over time, offset the
decline in copper-based special access services provided to wireless
carriers as they migrate to Ethernet services, although the timing and
magnitude of this technological migration is uncertain.
º •
º Legacy services. Revenues from our legacy services represented 42% and
47% of our total revenues for the successor three months ended
September 30, 2012 and 2011, respectively, and 43% and 48% of our
total revenues for the successor nine months ended September 30, 2012 and the combined nine months ended September 30, 2011, respectively,
and we expect that this percentage will continue to decline. Our
legacy services revenues have been, and we expect they will continue
to be, adversely affected by access line losses. Intense competition
and product substitution continue to drive our access line losses. For
example, many consumers are replacing traditional voice
telecommunications service with substitute services, including
(i) cable and wireless voice services and (ii) electronic mail,
texting and social networking services. We expect that these factors
will continue to negatively impact our business. As a result of the
expected loss of access line revenues, we continue to offer service
bundling and other product promotions to help mitigate this trend, as
described below.
º •
º Data integration. We expect both data integration revenue and the
related costs will fluctuate from quarter to quarter as this offering
tends to be more sensitive than others to changes in the economy and
in spending trends of our federal government customers.
º •
º Service bundling and product promotions. We offer our customers the
ability to bundle multiple products and services. These customers can
bundle local services with other services such as broadband, video,
long-distance and wireless. While our video and wireless services are
an important piece of our customer retention strategy, they do not significantly contribute to our strategic services revenues. However,
we believe customers value the convenience of, and price discounts
associated with, receiving multiple services through a single company.
While bundle price discounts have resulted in lower average revenues
for our individual products, we believe service bundles continue to
positively impact our customer retention and our ability to compete
with other telecommunications service providers. In addition to our
bundle discounts, we also offer from time to time limited time
promotions on our broadband service, which we believe further aids our
ability to attract and retain customers and increase usage of our
services.
º •
º Operating efficiencies. We continue to evaluate our operating structure and focus. This involves balancing our workforce in response
to our workload requirements, productivity improvements and changes in
industry, competitive, technological and regulatory conditions.
º •
º Pension and post-retirement benefits expenses. We are required to recognize in our consolidated financial statements certain expenses
relating to our pension and post-retirement health care and life
insurance benefits plans. These expenses are calculated based on
several assumptions, including among other things discount rates and
expected rates of return on plan assets that are generally set at
December 31 of each year. Changes in these assumptions can cause significant changes in the combined net periodic benefits expenses we
recognize. We allocate the expenses of these plans to certain of our
other affiliates. The allocation of expenses is based upon the
demographics of employees and retirees at our affiliates. Changes in
our assumptions can cause significant changes in the net periodic
pension and post-retirement benefits expenses we recognize.
º •
º Strategic capital investment. Our capital expenditures continue to be focused on our strategic services such as broadband and the deployment
of fiber to the tower ("FTTT"). FTTT is a type of telecommunications
network consisting of fiber-optic cables that run from a wireless
carrier's mobile telephone switching office to cellular towers to
enable the delivery of higher bandwidth
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services supporting mobile technologies than would otherwise generally
be available through a more traditional copper-based
telecommunications network.
While these trends are important to understanding and evaluating our
financial results, the other transactions, additional events, uncertainties and
trends discussed in "Risk Factors" in Item 1A of Part II of this report may also
materially impact our business operations and financial results.
Results of Operations
Successor Predecessor Combined
Three Months Three Months Nine Months Six Months Three Months Nine Months
Ended Ended Ended Ended Ended Ended
September 30, September 30, September 30, September 30, March 31, September 30,
2012 2011 2012 2011 2011 2011
(Dollars in millions)
Operating
revenues $ 2,825 2,765 8,500 5,534 2,846 8,380
Operating
expenses 2,503 2,542 7,597 5,173 2,267 7,440
Operating
income 322 223 903 361 579 940
Other
income
(expense) (185 ) (158 ) (577 ) (309 ) (222 ) (531 )
Income
tax
expense 54 33 129 33 146 179
Net
income $ 83 32 197 19 211 230
The following table summarizes our results of operations:
The following table summarizes certain of our operational metrics:
Successor
As of As of
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(in thousands)
Broadband subscribers 3,284 3,139 145 5 %
Access lines 8,167 8,658 (491 ) (6 )%
Employees 24.9 27.3 (2.4 ) (9 )%
During the second quarter of 2012, we updated our methodology for counting
broadband subscribers to better align with the methodology used by our parent
company, CenturyLink. We have restated our previously reported amounts to
reflect this change. For additional information on our counting methodologies,
see "Overview" above.
Operating Revenues
The following tables summarize our operating revenues:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Strategic services $ 1,258 1,194 64 5 %
Legacy services 1,197 1,299 (102 ) (8 )%
Data integration 137 134 3 2 %
Affiliates and other
services 233 138 95 69 %
Total operating revenues $ 2,825 2,765 60 2 %
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Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Strategic
services $ 3,715 2,388 1,200 3,588 127 4 %
Legacy
services 3,681 2,632 1,400 4,032 (351 ) (9 )%
Data
integration 393 252 123 375 18 5 %
Affiliates
and other
services 711 262 123 385 326 85 %
Total
operating
revenues $ 8,500 5,534 2,846 8,380 120 1 %
Strategic Services
Strategic services revenues increased in both of the comparative periods
reflected in the tables above due to increases in the volumes of our Ethernet
and MPLS services. Broadband revenues also increased due to higher levels of
augmented modem sales and leases, DSL access, bundling and late fees. These
increases were partially offset by decreased sales volumes of our private line
and special access services.
Legacy Services
Legacy services revenues decreased in both of the comparative periods as a
result of lower local and long-distance services revenues due to access line
loss and reduced access services usage related to the above-described
competitive pressures and product substitution. Legacy services revenues also
decreased in both of the comparative periods due to lower revenues from our
traditional WAN services caused by customer migration, product substitution and
increased competition.
Data Integration
Revenues from data integration increased in both of the comparative periods
primarily due to increased equipment sales and professional services, including
network management, security and integration of customer premises equipment.
Affiliates and Other Services
Affiliates and other services revenues increased in both of the comparative
periods primarily due to a change in methodology effective January 1, 2012 that
resulted in both higher affiliate revenues and expenses for us. See Note 1-Basis
of Presentation. The remainder of this increase is attributable to increased USF
rates and telecommunications services we provided to affiliates since
CenturyLink's April 1, 2011 acquisition of us.
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Operating Expenses
The following tables summarize our operating expenses:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/ %
2012 2011 (Decrease) Change
(Dollars in millions)
Cost of services and
products (exclusive of
depreciation and
amortization) $ 1,227 1,185 42 4 %
Selling, general and
administrative 384 525 (141 ) (27 )%
Operating
expenses-affiliates 165 36 129 nm %
Depreciation and
amortization 727 796 (69 ) (9 )%
Total operating expenses $ 2,503 2,542 (39 ) (2 )%
Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Cost of services
and products
(exclusive of
depreciation and
amortization) $ 3,615 2,326 1,178 3,504 111 3 %
Selling, general
and administrative 1,312 1,181 556 1,737 (425 ) (24 )%
Operating
expenses-affiliates 464 68 - 68 396 nm %
Depreciation and
amortization 2,206 1,598 533 2,131 75 4 %
Total operating
expenses $ 7,597 5,173 2,267 7,440 157 2 %
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º nm
º - Percentages greater than 200% and comparisons between positive and
negative values or to/from zero values are considered not meaningful.
Effective January 1, 2012, we changed our rates of capitalized labor as we
transitioned certain legacy systems to the historical systems of our parent,
CenturyLink. This transition resulted in an estimated $30 million to $45 million
increase in the amount of labor capitalized as an asset compared to the amount
that would have been capitalized if we had continued to use our legacy systems
and a corresponding estimated $30 million to $45 million decrease in operating
expenses for the successor nine months ended September 30, 2012. This change is
expected to result in an estimated operating expense reduction of approximately
$35 million to $60 million for the successor year ending December 31, 2012.
Cost of Services and Products (exclusive of depreciation and amortization)
Cost of services and products (exclusive of depreciation and amortization)
are expenses incurred in providing products and services to our customers. These
expenses include: employee-related expenses directly attributable to operating
and maintaining our network (such as salaries, wages, benefits and
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professional fees); facilities expenses (which are expenses we incur from using
other carriers' networks to provide services to our customers); rents and
utilities expenses; equipment sales expenses (such as data integration and modem
expenses); costs for USF (which reflect our contributions to certain federal and
state funds that are established to promote the availability of
telecommunications services to all consumers at reasonable and affordable rates,
among other things); and other expenses directly related to our network and
hosting operations.
Cost of services and products expenses increased in both of the comparative
periods reflected in the tables above primarily due to increases in customer
premise equipment and maintenance costs, USF contribution rates, network
expenses and professional and credit card fees. These expenses were partially
offset by decreases in employee-related expenses due to changes in the salaries
and wages allocation, lower headcount reductions and PTO usage.
Selling, General and Administrative
Selling, general and administrative expenses are expenses incurred in
selling products and services to our customers, corporate overhead and certain
other operating expenses. These expenses include: employee-related expenses
(such as salaries, wages, internal commissions, benefits and professional fees)
directly attributable to selling products or services and employee-related
expenses for administrative functions; marketing and advertising; taxes (such as
property and other taxes) and fees; external commissions; bad debt expense; and
other operating expenses.
These expenses decreased in both of the comparative periods reflected in the
tables above primarily due to lower employee related expenses and decreases in
pension expense and marketing and advertising. Higher insurance and fees and
external commissions partially offset these decreases.
Operating Expenses-Affiliates
Effective January 1, 2012, in connection with post-acquisition systems
integration activities, we adopted the affiliate expense allocation methodology
used by our parent. This methodology results in certain overhead costs incurred
by us and by our parent that were previously assessed to us on a net basis now
being assessed on a gross basis both to and from our parent, resulting in both
higher affiliate revenues and expenses for us. We believe this change, resulting
from systems integration activities, did not have a significant impact to our
net income for the successor three and nine months ended September 30, 2012.
Since CenturyLink's acquisition of us, we have incurred affiliates expenses
related to our use of telecommunications services, marketing and employee
related support services provided to us by CenturyLink and certain of its
subsidiaries. Increases in operating expenses-affiliates for the successor nine
months ended September 30, 2012 compared to the combined nine months ended
September 30, 2011 are primarily due to increased affiliate transactions
attributable to incurring intercompany expenses for the entire 2012 period
compared to only part of the 2011 period.
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Depreciation and Amortization
The following tables provide detail regarding depreciation and amortization
expense:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Depreciation $ 380 401 (21 ) (5 )%
Amortization 347 395 (48 ) (12 )%
Total depreciation and
amortization $ 727 796 (69 ) (9 )%
Increase/
Successor Predecessor Combined (Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Depreciation $ 1,132 804 475 1,279 (147 ) (11 )%
Amortization 1,074 794 58 852 222 26 %
Total
depreciation
and
amortization $ 2,206 1,598 533 2,131 75 4 %
In connection with us being acquired as of April 1, 2011, our property,
plant and equipment was recognized at fair value, which reduced the recognized
amounts of our net property, plant and equipment. This decrease in asset value
resulted in $77 million lower depreciation expense for the successor nine months
ended September 30, 2012, as compared to the combined nine months ended
September 30, 2011. Effective January 1, 2012, we also changed our estimates of
the economic lives of certain telecommunications equipment. These changes
resulted in an additional decrease to depreciation expense of approximately
$23 million and $69 million for the successor three and nine months ended
September 30, 2012, respectively. Excluding the effects of CenturyLink's
acquisition of us, depreciation expense decreased for both comparative periods
reflected in the tables above due to annual updates of our depreciation rates
for capitalized assets, which were partially offset by net growth in capital
assets.
The accounting for CenturyLink's acquisition of us also resulted in
additional amortizable intangible assets, which increased amortization expense
approximately $259 million for the successor nine months ended September 30,
2012, as compared to the combined nine months ended September 30, 2011. In
addition, our capitalized software was also recognized at fair value, which
resulted in an increase of $59 million in amortization expense for the successor
nine months ended September 30, 2012, as compared to the combined nine months
ended September 30, 2011. Excluding the effects of CenturyLink's acquisition of
us, amortization expenses decreased by $27 million and $67 million for the
successor three and nine months ended September 30, 2012, due to lower net
investment in our capitalized software.
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Other Consolidated Results
The following tables summarize our total other income (expense) and income
tax expense:
Successor
Three Months Three Months
Ended Ended
September 30, September 30, Increase/
2012 2011 (Decrease) % Change
(Dollars in millions)
Interest expense $ (147 ) (158 ) (11 ) (7 )%
Interest
expense-affiliates (37 ) - 37 nm %
Other (expense) income (1 ) - 1 nm %
Total other income
(expense) $ (185 ) (158 ) 27 17 %
Income tax expense $ 54 33 21 64 %
Successor Predecessor Combined Increase/(Decrease) % Change
Nine Months Six Months Three Months Nine Months Successor Successor
Ended Ended Ended Ended 2012 v 2012 v
September 30, September 30, March 31, September 30, Combined Combined
2012 2011 2011 2011 2011 2011
(Dollars in millions)
Interest expense $ (471 ) (308 ) (227 ) (535 ) (64 ) (12 )%
Interest
expense-affiliates (71 ) - - - 71 nm %
Net loss on early
retirement of debt (38 ) (1 ) - (1 ) 37 nm %
Other income 3 - 5 5 (2 ) (40 )%
Total other income
(expense) $ (577 ) (309 ) (222 ) (531 ) 46 9 %
Income tax expense $ 129 33 146 179 (50 ) (28 )%
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º nm
º - Percentages greater than 200% and comparisons between positive and
negative values or to/from zero values are considered not meaningful.
Interest Expense
Interest expense decreased for both comparative periods reflected in the
tables above due to lower interest expense on amounts owed to third parties. The
decrease in non-affiliate interest expense was primarily due to a significant
reduction in debt during the preceding twelve months along with increased
capitalized interest. See Liquidity and Capital Resources for the details of
these net redemptions.
Interest Expense-Affiliates
Affiliate interest expense increased for both comparative periods reflected
in the tables above primarily due to increased affiliate loan balances, which
QCII used to retire several debt securities during the preceding twelve months.
The increase is also due to CenturyLink's cash management arrangement between
certain of its subsidiaries, including us, under which the majority of our cash
balance is transferred on a daily basis to CenturyLink. We report the balance of
these transfers on our balance sheet as advances to affiliates.
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Net Loss on Early Retirement of Debt
During the second quarter of 2012, QCII redeemed $500 million of its 7.50%
Notes due 2014, which resulted in an immaterial gain. During the second quarter
of 2012, Qwest Corporation ("QC") completed a premium-priced cash tender offer
to purchase a portion of its $811 million of 8.375% Notes due 2016 and its
$400 million of 7.625% Notes due 2015. With respect to its 8.375% Notes due
2016, QC received and accepted tenders of approximately $575 million aggregate
principal amount of these notes, or 71%, for $722 million including a premium,
fees and accrued interest. With respect to its 7.625% Notes due 2015, QC
received and accepted tenders of approximately $308 million aggregate principal
amount of these notes, or 77%, for $369 million including a premium, fees and
accrued interest. The completion of this tender offer resulted in a loss of
$46 million.
In the first quarter of 2012, QCII redeemed $800 million of its 7.50% Notes
due 2014, which resulted in a gain of $8 million.
Income Tax Expense
Income tax expense for the successor nine months ended September 30, 2012
was $129 million, or an effective tax rate of 39.6%, as compared to income tax
expense for the combined nine months ended September 30, 2011 of $179 million,
or an effective tax rate of 43.8%. The decrease in the effective tax rate is
primarily due to a decrease in the state tax rate for 2012 and a 2011 increase
in the valuation allowance against estimated deferred tax assets that require
income of a special character or location for which we were not more likely than
not to generate.
Liquidity and Capital Resources
Overview
We are a wholly owned subsidiary of CenturyLink. As such, factors relating
to, or affecting, CenturyLink's liquidity and capital resources could have
material impacts on us, including impacts on our credit ratings, our access to
capital markets and changes in the financial market's perception of us.
CenturyLink has cash management arrangements between certain of its
subsidiaries that include lines of credit, affiliate obligations, capital
contributions and dividends. As part of these cash management arrangements,
affiliates provide lines of credit to certain other affiliates. Amounts
outstanding under these lines of credit and intercompany obligations vary from
time to time. Under these arrangements, the majority of our cash balance is
advanced on a daily basis to CenturyLink. From time to time we may declare and
pay dividends to CenturyLink, using cash repaid to us under these advances,
which has the net effect of reducing the amount of these advances. Given our
upgrade to an investment grade rating on April 1, 2011 by one of the rating
agencies, our debt covenants do not currently limit the amount of dividends we
can pay to CenturyLink. Given our cash management arrangement with CenturyLink
and the resulting amounts due to us from CenturyLink, a significant component of
our liquidity is dependent upon CenturyLink's ability to repay its obligation to
us.
As of the successor date of September 30, 2012, we had a working capital
deficit of $2.8 billion, reflecting current liabilities of $5.7 billion and
current assets of $2.9 billion, compared to a working capital deficit of
$280 million as of the successor date of December 31, 2011. The change in our
working capital position is primarily due to the establishment of on demand
notes payable-affiliates upon the redemption of certain of our bonds during
2012. The $2 billion increase in notes payable-affiliates and the $740 million
increase in current maturities of long-term debt, partially offset reductions in
the amounts owed to us by our affiliates and our accounts payable and dividends
payable balances.
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Revolving Promissory Note
We have a revolving promissory note with an affiliate of CenturyLink that
provides us with a funding commitment with an aggregate principle amount
available to $3.0 billion through June 30, 2022 and $1,985 million outstanding
as of the successor date of September 30, 2012. The revolving promissory note is
subordinated to our Senior Notes. Interest is accrued on the outstanding balance
using a weighted average per annum interest rate of CenturyLink's outstanding
borrowings for the interest period. As of September 30, 2012, the weighted
average interest rate was 6.0917%. The accrued interest and outstanding
principle balance are payable on demand, and if no demand, then on June 30,
2022. This revolving promissory note is reflected on our consolidated balance
sheets under "Notes payable-affiliates".
Debt and Other Financing Arrangements
Subject to market conditions, we expect to continue to issue debt securities
from time to time through QC to refinance its maturing debt. The availability,
interest rate and other terms of any new borrowings will depend on the ratings
assigned to QC by the three major credit rating agencies, among other factors.
On October 26, 2012, QCII redeemed all $550 million of its 8.00% Notes due
2015 using funds borrowed under CenturyLink's Credit Facility. This redemption
resulted in a gain of $15 million.
As of the successor date of September 30, 2012, we believe we were in
compliance with the provisions and covenants of our debt agreements.
Capital Expenditures
We incur capital expenditures on an ongoing basis in order to enhance and
modernize our networks, compete effectively in our markets and expand our
service offerings. We evaluate capital expenditure projects based on a variety
of factors, including expected strategic impacts (such as forecasted revenue
growth or productivity, expense and service impacts) and our expected return on
investment. The amount of capital investment is influenced by, among other
things, demand for our services and products, cash generated by operating
activities and regulatory considerations. Our 2012 capital expenditures will be
determined in part by the strategic initiatives of our parent, CenturyLink.
Our capital expenditures continue to be focused on primarily our broadband
services. In particular, we will continue to focus on expanding our fiber
infrastructure, including installations of "fiber to the tower", or FTTT. FTTT
is a type of telecommunications network consisting of fiber-optic cables that
run from a wireless carrier's mobile telephone switching office to cellular
towers to enable the delivery of higher bandwidth services supporting mobile
technologies than would otherwise generally be available through a more
traditional copper-based telecommunications network.
CenturyLink has agreed to accept approximately $35 million of the
$90 million available to it from Phase 1 of the Federal Communications
Commission's ("FCC") Connect America Fund ("CAF") established by Congress to
help telecommunications carriers defray the cost of providing broadband access
to remote customers. Of the $35 million, QC will receive approximately
$30 million and intends to use the funds to deploy broadband service for up to
39,000 homes in unserved rural areas principally in Colorado, Minnesota, New
Mexico and Washington. CenturyLink has determined that restrictions on the use
of these funds have made acceptance of additional CAF funds uneconomical.
CenturyLink has, however, filed with the FCC a waiver application, which, if
granted, would allow QC to deploy broadband services with CAF funds to
approximately 56,000 more homes in high-cost unserved areas in its markets.
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Pension and Post-retirement Benefit Obligations
We are subject to material obligations under our existing defined benefit
pension plan and other post-retirement benefit plans. The accounting funding
status of our plans is measured annually at December 31. As of the successor
date of December 31, 2011, the accounting unfunded status of our pension and
other post-retirement benefit obligations was $650 million and $2.7 billion,
respectively. See Note 8-Employee Benefits of our Form 10-K for the year ended
December 31, 2011 for additional information about our pension and other
post-retirement benefit arrangements.
Benefits paid by our qualified pension plan are paid through a trust and
contributions required to be made to the trust are governed by the Employee
Retirement Income Security Act of 1974, as amended. On July 6, 2012, the Moving
Ahead for Progress in the 21st Century Act ("MAP-21") was signed into law. This
legislation contains pension-related provisions which, among other things,
provide near-term relief from the impact of recent low interest rates on pension
funding requirements and an increase in the premiums paid to the Pension Benefit
Guaranty Corporation ("PBGC"). Under MAP-21, companies will be permitted to
calculate their pension obligations based on 25-year historic average rates,
which exceed the two-year average rates being used prior to the legislation.
Consequently, this legislation will lower the amount of required pension plan
contributions. This relief is available commencing in 2012, but gradually
decreases each year through 2016, at which time the reduced level of relief is
frozen with respect to future years. Based on several assumptions, we have
projected that this relief will reduce our pension plan funding requirements
over the next five years by approximately $600 million, which will
correspondingly enhance our cash flows over this period. The legislation will
not, however, affect pension liabilities recorded on our financial statements
under generally accepted accounting principles and, consequently, the near-term
funding relief could increase our future pension plan contributions in later
years. Partially, offsetting this benefit, MAP-21 provides for an annual
increase beginning in 2013 to both the fixed premiums, based on plan
participants, and the variable premiums, based on unfunded vested benefits, paid
to PBGC. Based on various assumptions, we estimate that our premiums payable to
PBGC through 2016 will increase by $38 million as a result of the new
legislation. The actual amount of required contributions to our plans, and
premiums paid to PBGC, will depend on earnings on plan investments, prevailing
interest and discount rates, demographic experience, changes in plan benefits
and any further changes in funding laws and regulations.
Certain of our post-retirement health care and life insurance benefits plans
are unfunded. A trust holds assets that are used to help cover the health care
costs of certain retirees. As of December 31, 2011, the fair value of the trust
assets was $643 million; however, a portion of these assets is comprised of
investments with restricted liquidity. We estimate that the more liquid assets
in the trust will be adequate to provide continuing reimbursements for covered
post-retirement health care costs for approximately four years, based on current
circumstances. Thereafter, covered benefits will be paid either directly by us
or from the trust as the remaining assets become liquid. This projected four
year period could be substantially shorter or longer depending on changes in
projected health care costs, returns on plan assets, the timing of maturities of
illiquid plan assets and future changes in benefits.
Our estimated annual long-term rate of return on the pension and
post-retirement plans trust assets is 7.5% based on the assets currently held;
however, actual returns could vary widely in any given year.
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Historical Information
The following table summarizes our cash flow activities:
Increase/
Successor Predecessor Combined (Decrease)
Nine Months Six Months Three Months Nine Months Successor
Ended Ended Ended Ended 2012 v
September 30, September 30, March 31, September 30, Combined
2012 2011 2011 2011 2011
(Dollars in millions)
Net cash
provided
by
operating
activities $ 2,017 1,544 777 2,321 (304 )
Net cash
used in
investing
activities (1,016 ) (1,890 ) (408 ) (2,298 ) (1,282 )
Net cash
used in
financing
activities (995 ) (8 ) (317 ) (325 ) 670
Net cash provided by operating activities decreased primarily due to a
reduction in accounts payable-affiliates. For additional information about our
operating results, see "Results of Operations" above.
Net cash used in investing activities decreased in the successor nine months
ended September 30, 2012 primarily due to changes in advances to affiliates.
During the combined nine months ended September 30, 2011, our cash management
arrangement with CenturyLink resulted in the sweep of cash generating in excess
of capital expenditures of a significant amount while during the successor nine
months ended September 30, 2012, such excess was absorbed by dividends payable
to our parent. These decreases were partially offset by $133 million provided by
proceeds from the sale of property during the successor nine months ended
September 30, 2012.
Net cash used in financing activities increased in the successor nine months
ended September 30, 2012 as compared to the combined nine months ended
September 30, 2011, primarily due to $1.7 billion of additional payments of
long-term debt and increased dividends paid along with costs associated with
early retirement of debt. These increases were partially offset by significant
net debt paydown against the creation of notes payable-affiliates.
On July 20, 2012, QC redeemed all $484 million of its 7.50% Notes due 2023,
which resulted in an immaterial loss.
On June 25, 2012, QC issued $400 million aggregate principal amount of 7.00%
Notes due 2052 in exchange for net proceeds, after deducting underwriting
discounts and expenses, of $387 million. The Notes are unsecured obligations and
may be redeemed, in whole or in part, on or after July 1, 2017 at a redemption
price equal to 100% of the principal amount redeemed plus accrued interest.
On May 17, 2012, QCII redeemed $500 million of its 7.50% Notes due 2014,
which resulted in an immaterial gain.
On April 18, 2012, CenturyLink entered into a term loan in the amount of
$440 million, which has been guaranteed by QCII and its wholly-owned subsidiary,
QSC.
On April 18, 2012, QC completed a cash tender offer to purchase a portion of
its $811 million of 8.375% Notes due 2016 and its $400 million of 7.625% Notes
due 2015. With respect to its 8.375% Notes due 2016, QC received and accepted
tenders of approximately $575 million aggregate principal amount of these notes,
or 71%, for $722 million including a premium, fees and accrued interest. With
respect to its 7.625% Notes due 2015, QC received and accepted tenders of
approximately $308 million aggregate principal amount of these notes, or 77%,
for $369 million including a premium, fees and accrued interest. The completion
of this tender offer resulted in a loss of $46 million. In connection with
consummating this tender offer, QC borrowed from a CenturyLink affiliate
approximately
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$583 million under a revolving promissory note, payable upon demand. The
promissory note is unsecured and is pari passu to QC's senior notes.
On April 2, 2012, QC issued $525 million aggregate principal amount of 7.00%
Notes due 2052 in exchange for net proceeds, after deducting underwriting
discounts and expenses, of $508 million. The Notes are unsecured obligations and
may be redeemed, in whole or in part, on or after April 1, 2017 at a redemption
price equal to 100% of the principal amount redeemed plus accrued interest.
On March 1, 2012, QCII redeemed $800 million of its 7.50% Notes due 2014,
which resulted in an immaterial gain.
Certain Matters Related to CenturyLink's Acquisition of Us
Effective after CenturyLink's acquisition of us, we are included in the
consolidated federal income tax return of CenturyLink. CenturyLink is in the
process of developing a post-acquisition intercompany agreement for allocation
of consolidated income tax liabilities. We will continue to account for income
tax expense on a stand-alone basis. We are also included in certain combined
state tax returns filed by CenturyLink and the same accounting will apply.
As of the successor date of September 30, 2012, we paid certain costs that
were associated with CenturyLink's acquisition of us. These costs include
compensation costs comprised of retention bonuses and severance. The final
amounts and timing of the compensation costs to be paid is partially dependent
upon personnel decisions that continue to be made as part of the continuing
integration process. These amounts may be material.
In accounting for CenturyLink's acquisition of us, we recognized our debt
securities at their estimated fair values, which totaled $12.292 billion as of
April 1, 2011. Our acquisition date fair value estimates were based primarily on
quoted market prices in active markets and other observable inputs where quoted
market prices were not available. The fair value of our debt securities exceeded
their stated principal balances on the acquisition date by $693 million, which
we recorded as premium.
The table below summarizes the premiums recognized as a reduction to
interest expense or extinguished during the periods indicated:
Successor
Nine Months Nine Months
Ended Ended
September 30, December 31, Total
2012 2011 Since Acquisition
(Dollars in millions)
Amortized $ 68 154 222
Extinguished(1) 140 58 198
Total premiums recognized $ 208 212 420
--------------------------------------------------------------------------------
º (1)
º See "Debt and Other Financing Arrangements" for more information.
The remaining premium of $273 million as of the successor date of
September 30, 2012 will reduce interest expense in future periods, unless
otherwise extinguished.
Other Matters
We also are involved in various legal proceedings that could have a material
adverse effect on our financial position. See Note 9-Commitment and
Contingencies for the current status of such legal proceedings.
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Approximately 52% of our employees are subject to collective bargaining
agreements that expired on October 6, 2012. Our parent company, CenturyLink, is
currently negotiating the terms of new agreements. In the meantime, the
predecessor agreements have been extended, and the unions have agreed to provide
us with at least a twenty-four hour advance notice before terminating those
predecessor agreements. Any strikes or other changes in our labor relations
could have a significant impact on our business. See "Risk Factors-Other Risks"
in Item 1A. of Part II of this report. If we fail to extend or renegotiate our
collective bargaining agreement with our labor unions as they expire from time
to time, or if our unionized employees were to engage in a strike or other work
stoppage, our business and operating results could be materially harmed. To help
mitigate this potential risk, we have established contingency plans in which we
would assign trained, non-represented employees to cover jobs for represented
employees in the event of a work stoppage to provide continuity for our
customers.
Off-Balance Sheet Arrangements
There were no substantial changes to our contractual obligations in the
successor nine months ended September 30, 2012, when compared to the disclosures
provided in our Annual Report on Form 10-K for the year ended December 31, 2011.
Market Risk
We are exposed to market risk from changes in interest rates on our variable
rate long-term debt obligations. We seek to maintain a favorable mix of fixed
and variable rate debt in an effort to limit interest costs and cash flow
volatility resulting from changes in rates.
From time to time, we have used derivative instruments to (i) lock-in or
swap our exposure to changing or variable interest rates for fixed interest
rates or (ii) to swap obligations to pay fixed interest rates for variable
interest rates. As of the successor date of September 30, 2012, we had no such
instruments outstanding.
There were no material changes to market risks arising from changes in
interest rates for the successor nine months ended September 30, 2012, when
compared to the disclosures provided in our Annual Report on Form 10-K for the
year ended December 31, 2011.
Other Information
Our website is the same as that of our parent company, CenturyLink, which is
www.centurylink.com. We routinely post important investor information in the
"Investor Relations" section of our website at ir.centurylink.com. The
information contained on, or that may be accessed through, our website is not
part of this quarterly report. You may obtain free electronic copies of our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and all amendments to those reports in the "Investor Relations" section
of our website (ir.centurylink.com) under the heading "SEC Filings." These
reports are available on our website as soon as reasonably practicable after we
electronically file them with the SEC.
In addition to historical information, this MD&A includes certain
forward-looking statements that are based on current expectations only, and are
subject to a number of risks, uncertainties and assumptions, many of which are
beyond our control. Actual events and results may differ materially from those
anticipated, estimated or projected if one or more of these risks or
uncertainties materialize, or if underlying assumptions prove incorrect. Factors
that could affect actual results include but are not limited to: the timing,
success and overall effects of competition from a wide variety of competitive
providers; the risks inherent in rapid technological change; the effects of
ongoing changes in the regulation of the communications industry (including
those arising out of the Federal Communications Commission's October 27, 2011
order regarding intercarrier compensation and the USF, among other things); our
ability to
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successfully negotiate collective bargaining agreements on reasonable terms
without work stoppages; our ability to effectively adjust to changes in the
communications industry and changes in the composition of our markets and
product mix caused by CenturyLink's recent acquisitions; CenturyLink's ability
to successfully integrate recently-acquired operations into its incumbent
operations, including the possibility that the anticipated benefits from these
recent acquisitions cannot be fully realized in a timely manner or at all, or
that integrating the acquired operations will be more difficult, disruptive or
costly than anticipated; CenturyLink's and our ability to use net operating loss
carryovers in projected amounts; CenturyLink's ability to effectively manage its
expansion opportunities, including retaining and hiring key personnel; possible
changes in the demand for, or pricing of, our products and services; our ability
to successfully introduce new product or service offerings on a timely and
cost-effective basis; our continued access to credit markets on favorable terms;
our ability to collect our receivables from financially troubled communications
companies; any adverse developments in legal proceedings involving CenturyLink
or us; unanticipated increases or other changes in our future cash requirements,
whether caused by unanticipated increases in capital expenditures, increases in
CenturyLink's or our pension funding requirements or otherwise; the effects of
adverse weather; other risks referenced from time to time in this report
(including in "Risk Factors" in Item 1A of Part II of this report) or other of
our filings with the SEC; and the effects of more general factors such as
changes in interest rates, in tax rates, in accounting policies or practices, in
operating, medical, pension or administrative costs, in general market, labor or
economic conditions, or in legislation, regulation or public policy. You should
be aware that new factors may emerge from time to time and it is not possible
for us to identify all such factors nor can we predict the impact of each such
factor on the business or the extent to which any one or more factors may cause
actual results to differ from those reflected in any forward-looking statements.
You are further cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date of this report. We undertake no
obligation to update any of our forward-looking statements for any reason.
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